Ebook Taking Firms and Markets Seriously: A Study on Bank Behavior, Market Discipline, and Regulatory Policy
When analyzing regulatory policy political scientist have focused almost exclusively on government and interest group behavior. We submit that particularly with respect to economic policy this top-down perspective should be complemented by a bottom-up view that systematically accounts, from the micro-level upwards, for the behavior of economic actors and markets and their implications for regulatory policy.
We examine the US banking sector and its regulation in the 1990s to gain insights on how studies of this nature could be constructed. We focus on the banking sector because it is characterized both by market competition and extensive government regulation. The banking sector thus provides us with an excellent opportunity to examine a crucial area of economic policy through the lens of bank behavior and market processes, and to complement existing studies in political science that have analyzed regulatory policy primarily from the perspective of the regulator (e.g., Murphy 1999, 2004; Lutz 2000; Simmons 1999).
Since the late 1980s national authorities from the G-10 and some other countries have been engaged in increasingly complex national and international regulatory reforms in the banking sector. The aim of regulatory activity, a large part of which concentrates on the capitalization of banks, notably capital-asset ratios (CAR), has been to mitigate bank solvency problems that could destabilize national and international financial systems. The motivation behind the proliferation of regulatory activity is found in the presumption that banks, if left alone, would select to remain undercapitalized relative to the level required for bank solvency.
Surprisingly, a glance at Figure 1 reveals no tendencies for under capitalization. On the contrary, banks systematically and significantly over-comply with regard to capitalization standards set by government (Figure A1 reveals a similar tendency at the international level). Why do banks select such high levels of capital that appear to render regulation redundant? It has been suggested that market discipline may be responsible for this puzzling behavior. In particular, in the absence of explicit or implicit, catholic – that is, covering all types of bank liabilities – guarantees by the government, banks may have an incentive to satisfy "implicit capital adequacy requirements" in order to lower their riskiness and hence create liabilities at more favorable terms. In this paper we examine the quantitative significance of this mechanism by studying the entire population of US banks in the 1990s (approximately 130,000 bank-years). We find that better capitalized banks indeed experience lower borrowing costs and that this effect is substantial (elasticity of –0.5).
Having established that market discipline is likely to have mitigated bank solvency problems, we turn to a more general question: can market competition also counter the free riding problems that exist in the banking sector due to systemic risk? We first show, from a theoretical viewpoint, that whether the banking sector is under- or over-capitalized relative to the social optimum depends on the relative importance of idiosyncratic bank risk (the risk profile of individual banks) and systemic risk (the "healthiness" of the entire banking sector) for banks' borrowing costs. Undercapitalization – and hence a need for regulation – is more likely to occur when systemic bank risk dominates. We also argue that the presence of other government interventions, such as government deposit insurance and government-led bank bailouts, makes undercapitalization more likely. We then examine empirically whether the effect of market discipline on bank capital dominates that of free riding. We find that this is not the case; that is banks are undercapitalized relative to the social optimum, even when they are overcapitalized relative to the governmental regulatory requirements.
We can draw at least two conclusions from these findings. First, at the most general level, our findings support the argument by Downs, Rocke and Barsoom (1996), that regulatory standards, compliance levels, and enforcement must be conceptualized as endogenous variables, and that stronger regulation and deeper international cooperation usually requires stronger enforcement. Interactions of these three variables in the banking case are clearly characterized by complementarities between regulatory and market forces; that is, regulatory policy and market competition have reinforced each other. Stronger regulation and deeper international cooperation (Basle Accord) has required more enforcement, and market forces have helped governments achieve stronger enforcement. In the context of our analysis, regulation that increases transparency (such as reporting requirements for bank capitalization) can create and sustain competition among economic actors (banks), and can thus play an important role in mitigating the problems that motivate governmental regulatory activity. Regulators have been quite aware of this complementarity. One may in fact argue that the main element of national and international (Basle Accord) regulation of bank capital has not been the imposition of minimum capital requirements per se, but rather how these regulations have transformed the financial market. In particular, they have increased transparency and hence competition by demanding that banks adhere to well defined capital requirements, which are reported publicly and are easily comparable across banks and countries. The increased market pressure that followed these measures has promoted compliance and even over-compliance as banks rushed to raise capital levels in order to signal their quality. These mutually reinforcing effects of regulation and competition have transformed policy-making in this area. While policy-makers and banks were, in the 1980s and 1990s, very much focused on defining minimum capitalization levels to create a level playing field for banks at national and international levels (Oatley and Nabors 1998) current efforts concentrate much more on how to measure risk and how to enhance transparency. We can interpret the latter policies as efforts to align market forces and regulation more effectively in ways that minimize the need for costly government enforcement or bailouts.
Second, it seems worthwhile to examine whether similar complementarities exist in other areas of national and international policy-making, how they function, or if they do not exist why so and how they could be created. Obvious candidates for such analyses include corporate environmental performance and social responsibility standards, accounting rules, and corporate governance rules (see, e.g., Murphy 2004; Vogel 2006; Prakash and Potoski 2006). Take corporate accounting standards as an example. To the extent that corporate scandals (e.g., Enron and Parmalat) have sensitized global markets, firms may have an incentive to adopt greater transparency and best practice accounting standards to lower their borrowing costs and/or draw funds from global equity markets (the same way that banks increase their capitalization beyond that required by regulators to improve their competitive position). That is, firms can signal their quality to financial markets by adopting more transparent and stringent standards. The fact that the most important firms in a large number of countries and industries are linked to global financial markets implies that such incentives are present throughout the world economy. Regulators can trigger and/or enhance this process by selecting the appropriate set of standards. To the extent that the appropriate standards are similar across countries there will be a tendency for international policy convergence and market forces will further promote convergence.
The following section reviews the relevant literature. Section three contains the theoretical model. In section four we present the results of the empirical analysis. Section five concludes.
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