The world wide financial crisis following the failure of Lehman Brothers in September 2008 has highlighted the importance of adequate banking regulation and supervision. The G20 recently approved a package of proposals of the Basel Committee on Banking Supervision to strengthen global capital and liquidity regulations in order to promote a more resilient banking sector.
In view of its importance, it is quite remarkable that only a limited number of studies have examined the impact of bank regulation and supervision on bank fragility. This probably reflects the difficulty to measure bank regulation and supervision. Essentially two sources of information have been used to construct proxies for bank regulation and supervision.
Some studies use an index measuring the extent to which countries adhere to the Core Principles for Effective Bank Supervision as issued by the Basel Committee on Banking Supervision (BCPs). A good example is the study by Demirgüç-Kunt et al. (2008) who find a positive relationship between financial soundness and the overall index of BCP compliance, but this result is sensitive to controlling for the institutional quality of the country and to the exclusion of outliers. More recently, Demirgüç-Kunt and Detragiache (2010) have explored whether BCP compliance affects bank soundness as proxied by the Z-score, defined as the number of standard deviations by which bank returns have to fall to exhaust bank equity. Using data for 3,000 banks from 86 countries, they do not find support for the hypothesis that better compliance with BCPs results in sounder banks.
Compliance with the BCPs is mostly classified information. Furthermore, the BCP compliance indicator may be weakly associated with bank soundness, because it proxies for the overall quality of the institutional and macroeconomic environment (Demirgüç-Kunt et al., 2008).
Alternatively, a few studies including the present one - employ the World Bank survey on supervision to construct measures of bank regulation and supervision. In several surveys, Barth et al. (2004; 2008) collected detailed and comprehensive information on bank regulation and supervision for more than 107 countries between 1999 and 2008. Barth et al. (2004) analyze the effect of different dimensions of bank regulation and supervision on bank stability using an earlier version of the survey dataset. Their findings suggest that policies that induce accurate information disclosure and (incentives for) private sector corporate control of banks work best to promote banking sector stability. Also Pasiouaris et al. (2006) use this survey to construct indicators of bank regulation and supervision. Employing bank level data from 71 countries and 857 banks, they find that various dimensions of bank regulation and supervision have a significant impact on bank ratings.
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Banking risk and regulation: Does one size fit all?
