A Normative Analysis of Banking Supervision: Independence, Legal Protection and Accountability

A Normative Analysis of Banking Supervision: Independence, Legal Protection and Accountability Jorge PONCE Jorge PONCE () Independence, Legal Protection and Accountability 1 / 1

Motivation Growing interest on the institutional organization of banking supervision: Basel Committee on Banking Supervision s (1997, 2006) Core Principles, Goodhart (1998, 2007), Lastra (1996), Masciandaro and Quintyn (2007, 2009), Quintyn and Taylor (2003), Rochet (2008) Non-appropriate institutional arrangements: Subprime crisis, Quintyn, Ramirez and Taylor (2007) Non-conclusive empirical evidence: Das, Quintyn and Chenard (2004): positive significant effects Barth, Caprio and Levine (2004, 2006): non-significant effects Masciandaro and Quintyn (2007, 2009) Jorge PONCE () Independence, Legal Protection and Accountability 2 / 1

Objectives Which are the characteristics that a supervisory arrangement should have to effectively implement a supervisory policy? This paper: Provides a formal model of a bank supervisor Derives policy implications Provides some empirical support Jorge PONCE () Independence, Legal Protection and Accountability 3 / 1

The Model: Agents, Technologies and Preferences A risk neutral banker: invests (fully insured) deposits (D = 1) on risky loans R u > R m > 1 > R d = 0 at maturity; R l < 1 before maturity decides whether or not to take excessive risks Jorge PONCE () Independence, Legal Protection and Accountability 4 / 1

The Model: Agents, Technologies and Preferences A risk neutral banker: invests (fully insured) deposits (D = 1) on risky loans R u > R m > 1 > R d = 0 at maturity; R l < 1 before maturity decides whether or not to take excessive risks A risk neutral bank supervisor: has authority to gather and to close down banks if effort, gets hard with probability µ receives a powerful incentive scheme: S = w p(w + c) Jorge PONCE () Independence, Legal Protection and Accountability 4 / 1

The Model: Agents, Technologies and Preferences A risk neutral banker: invests (fully insured) deposits (D = 1) on risky loans R u > R m > 1 > R d = 0 at maturity; R l < 1 before maturity decides whether or not to take excessive risks A risk neutral bank supervisor: has authority to gather and to close down banks if effort, gets hard with probability µ receives a powerful incentive scheme: S = w p(w + c) Politicians: the executive branch of the government maximize social welfare Jorge PONCE () Independence, Legal Protection and Accountability 4 / 1

The Model: Timing 1 Investment: risk taking decision 2 Information gathering: by shirking, supervisor gets B 3 Capture: a side-contract gives the supervisor b 4 Closure decision: Political independence: bank supervisor decides Political control: politicians decide 5 Returns: loans pay off 6 Monitoring: the incentive scheme is enforced Jorge PONCE () Independence, Legal Protection and Accountability 5 / 1

Benchmark: The First-best Outcome Expected Social Welfare: ( ) W = π θ d + 1 {risk taking} β f Jorge PONCE () Independence, Legal Protection and Accountability 6 / 1

Benchmark: The First-best Outcome Expected Social Welfare: ( ) W = π θ d + 1 {risk taking} β f First-best Outcome: Banker abstains from taking excessive risks Implementation: Commit to: gather close down excessively risky banks Jorge PONCE () Independence, Legal Protection and Accountability 6 / 1

The Problem of the Social Planner To give incentives to the bank supervisor in order he: gathers closes down excessively risky banks Normative viewpoint: characterize the optimal incentive scheme {w, p } Jorge PONCE () Independence, Legal Protection and Accountability 7 / 1

Key Elements: Political Independence Assume: political control politicians receive evidence that the bank is excessively risky Jorge PONCE () Independence, Legal Protection and Accountability 8 / 1

Key Elements: Political Independence Assume: political control politicians receive evidence that the bank is excessively risky Politicians Dynamic Commitment Problem: W risk taking W closure = [π (θ d + β)f ] [R l 1 f ] > 0 Result: The bank supervisor should have political independence Jorge PONCE () Independence, Legal Protection and Accountability 8 / 1

Key Elements: Accountability Arrangements Accountability: justify actions and be responsible: p > 0 Assume: political independence no accountability: p = 0 Jorge PONCE () Independence, Legal Protection and Accountability 9 / 1

Key Elements: Accountability Arrangements Accountability: justify actions and be responsible: p > 0 Assume: political independence no accountability: p = 0 Bank Supervisor Shirks and Blackmails Bankers: S p=0 = w Result: Appropriate accountability arrangements are necessary Jorge PONCE () Independence, Legal Protection and Accountability 9 / 1

Key Elements: Legal Protection Legal Protection: no punishment if closes down an excessively risky bank: p = 0 Assume: political independence, accountability and hard no legal protection: p1 > 0 if closes the bank down and shows p2 > p 1 otherwise Jorge PONCE () Independence, Legal Protection and Accountability 10 / 1

Key Elements: Legal Protection Legal Protection: Assume: no punishment if closes down an excessively risky bank: p = 0 political independence, accountability and hard no legal protection: p1 > 0 if closes the bank down and shows p2 > p 1 otherwise There is Scope for Capture: Result: S p2 + b S p1 if p 1 p 2 b w + c Legal protection reduces the scope for capture Jorge PONCE () Independence, Legal Protection and Accountability 10 / 1

The Optimal Incentive Scheme: {w, p } Supervisor: exerts effort µ Supervisor: gets hard shows Judge: gets hard Judge: observes right closure decision shirks 1 µ gets no hides gets no observes wrong closure decision cannot verify Jorge PONCE () Independence, Legal Protection and Accountability 11 / 1

The Optimal Incentive Scheme: {w, p } Supervisor: exerts effort µ Supervisor: gets hard shows Judge: gets hard Judge: observes right closure decision shirks 1 µ gets no hides gets no observes wrong closure decision cannot verify p (observes right closure decision) = 0 Jorge PONCE () Independence, Legal Protection and Accountability 11 / 1

The Optimal Incentive Scheme: {w, p } Supervisor: exerts effort µ Supervisor: gets hard shows Judge: gets hard Judge: observes right closure decision shirks 1 µ gets no hides gets no observes wrong closure decision cannot verify p (observes right closure decision) = 0 p (observes wrong closure decision) = 1 p (cannot verify) > 0 Jorge PONCE () Independence, Legal Protection and Accountability 11 / 1

The Optimal Incentive Scheme: {w, p } Supervisor: exerts effort µ Supervisor: gets hard shows Judge: gets hard Judge: observes right closure decision shirks 1 µ gets no hides gets no observes wrong closure decision cannot verify p (observes right closure decision) = 0 p (observes wrong closure decision) = 1 p (cannot verify) > 0 w > 0 Jorge PONCE () Independence, Legal Protection and Accountability 11 / 1

Policy Implications from the Optimal Incentive Scheme {w, p } w > 0 Policy Implications The optimal incentive scheme can be implemented by a Bank Supervisor s Charter Law or Statute, that: provides political independence for the bank supervisor Jorge PONCE () Independence, Legal Protection and Accountability 12 / 1

Policy Implications from the Optimal Incentive Scheme {w, p } w > 0 p (observes right closure decision) = 0 right closure decision = gather and show, and close down risky banks Policy Implications The optimal incentive scheme can be implemented by a Bank Supervisor s Charter Law or Statute, that: provides political independence for the bank supervisor provides legal protection for the bank supervisor Jorge PONCE () Independence, Legal Protection and Accountability 12 / 1

Policy Implications from the Optimal Incentive Scheme {w, p } w > 0 p (observes right closure decision) = 0 right closure decision = gather and show, and close down risky banks p (cannot verify or observes wrong closure decision) > 0 Policy Implications The optimal incentive scheme can be implemented by a Bank Supervisor s Charter Law or Statute, that: provides political independence for the bank supervisor provides legal protection for the bank supervisor specifies accountability arrangements Jorge PONCE () Independence, Legal Protection and Accountability 12 / 1

Empirical Strategy Pr(bank loans default) = { θ f + β θ f if excessive risk-taking otherwise Cross-country linear regression model: NPL i = a 1 + a 2 CP1 i + ɛ i Identification: If E(CP1, ɛ) = 0 and Var(CP1) = 0, then θ f = a 1 + a 2 and β = a 2 Data Set: Financial Sector Assessment Program (FSAP, IMF, WB) 78 countries 1999 2007 Jorge PONCE () Independence, Legal Protection and Accountability 13 / 1

OLS Results (1) CP1 (a 2 = β) -7.385*** (0.000) Constant (a 1 = θ f + β) 10.656*** (0.000) N 43 Adjusted R 2 0.356 Notes: Dependent variable: Non-performing loans to total loans. p-values are in parentheses. * significant at the 0.10 level, ** significant at the 0.05 level, *** significant at the 0.01 level. Jorge PONCE () Independence, Legal Protection and Accountability 14 / 1

OLS Results (1) (2) (3) (4) CP1 (a 2 = β) -7.385*** (0.000) Independence -4.191* (0.081) Legal -7.716*** Protection (0.000) Accountability -7.693*** (0.007) Constant (a 1 = θ f + β) 10.656*** 11.837*** 12.194*** 12.867*** (0.000) (0.000) (0.000) (0.000) N 43 71 59 50 Adjusted R 2 0.356 0.040 0.263 0.199 Notes: Dependent variable: Non-performing loans to total loans. p-values are in parentheses. * significant at the 0.10 level, ** significant at the 0.05 level, *** significant at the 0.01 level. Jorge PONCE () Independence, Legal Protection and Accountability 14 / 1

Robustness Checks Different construction of CP1 Statutory Control variables (exogenous determinants) macroeconomic factors (short-term interest rate, government s fiscal deficit, inflation rate, GDP growth rate, GDP per capita) institutional, regulatory and governance environment structure of the banking system (state-owned banks market share, concentration) historical determinants Instrumental variables measurement error problem third factors Jorge PONCE () Independence, Legal Protection and Accountability 15 / 1

Final Remarks Political independence, legal protection and accountability arrangements are necessary These arrangements reduce the ratio of NPL from 10 % to 3 % Legal protection and accountability are the key elements Jorge PONCE () Independence, Legal Protection and Accountability 16 / 1

Final Remarks Political independence, legal protection and accountability arrangements are necessary These arrangements reduce the ratio of NPL from 10 % to 3 % Legal protection and accountability are the key elements No independent supervisors: 30 % No accountable supervisors: 30 % No legally protected supervisors: 50 % Jorge PONCE () Independence, Legal Protection and Accountability 16 / 1

Final Remarks Political independence, legal protection and accountability arrangements are necessary These arrangements reduce the ratio of NPL from 10 % to 3 % Legal protection and accountability are the key elements No independent supervisors: 30 % No accountable supervisors: 30 % No legally protected supervisors: 50 % Final Remark Policy makers should still be persuaded that political independence, accountability and legal protection are key to successful reform Jorge PONCE () Independence, Legal Protection and Accountability 16 / 1