Author: Martin North

An IMF working paper published today entitled “High Liquidity Creation and Bank Failures”, suggests that regulators may want to consider incorporating liquidity creation into their early warning systems and subject high liquidity creators to additional oversight to either prevent bank failure or impose an orderly winding-down of the bank and limit taxpayer losses.

Identifying vulnerabilities which may lead to bank failure is a persistent challenge to regulators of financial systems and market analysts. Regulators seek timely warning of bank failures for an efficient deployment of monitoring resources and for enhancing regulation enforcement, and shareholders and taxpayers want to avoid substantial resolution costs as well as reduce the time involved in loss resolution.

Two hypotheses in the literature on bank fragility explain bank failures: the “Weak Fundamentals Hypothesis” (WFH) and the “Liquidity Shortage Hypothesis” (LSH). Under the WFH, poor bank fundamentals foreshadow an impending bank failure and CAMELS components are often used as the basis for an early warning system. Bank failures are thus information-based, as decaying capital ratios, reduced liquidity, deteriorating loan quality, and depleted earnings signal an increased likelihood of bank failure. In contrast, the LSH assumes that banks are solvent institutions but fragility is due to the irrational behavior of uninformed depositors who are unable to distinguish between liquidity and solvency shocks. According to this hypothesis, bank vulnerability to crises stems from the financing of illiquid assets with liquid liabilities. When exposed to an external shock and under the sequential servicing constraint, first-in-line depositors seek to withdraw all their deposits and, as the bank’s ability to meet deposit withdrawals declines, liquidity shortages become pronounced and the probability of failure increases.

The WFH focuses on asset risk to explain bank fragility and bank risk under the LSH arises from the liability side of the balance sheet. In this paper, we propose that bank vulnerability may result from the interaction between both asset and liability risks. Using new measures on liquidity creation, we postulate that banks’ vulnerability to failure may resultfrom a proliferation in the core activity of liquidity creation. We propose the “High Liquidity Creation Hypothesis” (HLCH) to explain bank failures, complementing the WFH (which identifies banks with weak fundamentals) and the LSH (which focuses on the inability of banks to meet liquidity commitments). According to the HLCH, a bank’s vulnerability increases when the core output measured by liquidity creation reaches high levels compared to other banks’ activities in the system.

To test this, we need a banking system that witnessed a number of bank failures which are unrelated to economic business cycles or triggered by adverse exogenous shocks. In Russia, over 200 banks failed between 2000 and 2007 and many of those failures were not associated with the business cycle. Thus, the banking system in Russia provides a natural field experiment to test as we are able to isolate the reasons for bank fragility independently from exogenous events.

To gauge the impact of high liquidity creation on the probability of bank failures, we perform logit regressions with bank random effects. We use different thresholds to define high liquidity creation in a given quarter, based on the distribution of the entire liquidity creation in the banking system. Our findings confirm the hypothesis that high liquidity creation increases the probability of bank failure, and the results are robust to several validity checks. Rather than suggesting an absolute cut-off value, we propose to screen financial intermediaries based on their liquidity creation ranking in the system. The identification of high liquidity creators allows regulators to at least place these banks on the watch list for enhanced oversight in view of reducing the number of failures in the system and strengthening incumbent institutions.

We propose a screening procedure of banks, ranking them based on their liquidity creation in the system. Specifically, we define high liquidity creators as banks with a liquidity creation level in a given quarter that exceeds the 90th percentile of the distribution. When liquidity creation becomes high, the probability of failure for such a bank increases significantly more than for other banks. Our results are robust to alternative measures of liquidity creation and definitions of bank failure, and controlling for bank location, market concentration, and regulatory changes. They are also in line with the theoretical predictions of Allen and Gale (2004) and empirical results for the U.S. (Berger and Bouwman, 2011).

The HLCH has two main implications. First, it suggests that liquidity creation by banks can be counterproductive when it becomes high. Liquidity creation above a certain threshold increases the probability of bank failure, eventually leading to the disappearance of the high liquidity-creating institution and even a reduction in the volume of aggregate liquidity creation in the economy. Therefore, regulatory authorities may need to give more attention to the liquidity-creating activities by banks when identifying vulnerabilities in the financial system. Second, our main finding provides insight for regulatory authorities to predict bank failures. Specifically, regulators may want to consider incorporating liquidity creation into their early warning systems and subject high liquidity creators to additional oversight to either prevent bank failure or impose an orderly winding-down of the bank and limit taxpayer losses.

An IMF Working Paper was released today, entitled “Does Basel Compliance Matter for Bank Performance?”.  They conclude that overall Basel compliance has no association with bank efficiency. This is important because the burden of compliance with international regulatory standards is becoming increasingly onerous, and financial institutions worldwide are developing compliance frameworks to enable management to meet more stringent regulatory standards. As regulators refine and improve their approach and methodologies, banks must respond to more stringent compliance requirements. This has implications for risk management and resource allocation, and, ultimately, on bank performance.

However, there is no evidence that any common set of best practices is universally appropriate for promoting well-functioning banks. Regulatory structures that will succeed in some countries may not constitute best practice in other countries that have different institutional settings. There is no broad cross-country evidence as to which of the many different regulations and supervisory practices employed around the world work best. As a consequence, the question of how regulation affects bank performance remains unanswered. Regulators around the world are still grappling with the question of what constitutes good regulation and which regulatory reforms they should undertake.

The global financial crisis underscored the importance of regulation and supervision to a well-functioning banking system that efficiently channels financial resources into investment. In this paper, we contribute to the ongoing policy debate by assessing whether compliance with international regulatory standards and protocols enhances bank operating efficiency. We focus specifically on the adoption of international capital standards and the Basel Core Principles for Effective Bank Supervision (BCP). The relationship between bank efficiency and regulatory compliance is investigated using the (Simar and Wilson 2007) double bootstrapping approach on an international sample of publicly listed banks. Our results indicate that overall BCP compliance, or indeed compliance with any of its individual chapters, has no association with bank efficiency.

From a theoretical perspective, scholars’ predictions as to the effects of regulation and supervision on bank performance are conflicting. The greater part of policy literature on financial regulation has been inspired by the broader debate on the role of government in the economy. The two best-known opposing camps in this field are the public interest and the private interest defenders, who both, nonetheless, agree on the assumption of market failure. For the public interest camp, governments regulate banks to ensure better functioning and thus more efficient banks, ultimately for the benefit of the economy and the society. For the private interest camp, regulation is a product of an interaction between supply; it is thus the outcome of private interests who use the coercive power of the state to extract rents at the expense of other groups.

According to the public interest view, which largely dominated thinking during the 20th century, regulators have sufficient information and enforcement powers to promote the public interest. In this setting, well-conceived regulation can exert a positive effect on firm behavior by fostering competition and encouraging effective governance in the sector. In contrast, according to the private interest view, efficiency may be distorted because firms are constrained to channel resources to special-interest groups. This implies that regulation may not play a role in improving bank efficiency. Kane (1977) suggested that these conflicting views help frame the complex motivations underlying regulatory policies. He argues that officials are subject to pressures to respond to both public and private interests, and that the outcome of such an oscillation depends on incentives. Swings in the approach to regulation reflect the interplay of industry and political forces and the occurrence of exogenous shocks (crises for example). These complex interactions may have conflicting effects on the efficiency of the banking system.

We focus on the adoption of international capital standards and the Basel Core Principles for Effective Bank Supervision (BCP). These principles, issued in 1997 by the Basel Committee on Bank Supervision, have since become the global standards for bank regulation, widely adopted by regulators in developed and developing countries. The severity of the 2007–09 financial crisis has cast doubt on the effectiveness of these global standards; regulatory reforms are under way in several countries. The initial crisis-induced assessment of regulatory failure is now giving way to a more complex regulatory dialogue and detailed evaluation of the principles underlying international regulatory standards as well as the implications of their adoption, in terms of banks’ safety and soundness. In addition, the burden of compliance with international regulatory standards is becoming increasingly onerous, and financial institutions worldwide are developing compliance frameworks to enable management to meet more stringent regulatory standards. As regulators refine and improve their approach and methodologies, banks must respond to more stringent compliance requirements. This has implications for risk management and resource allocation, and, ultimately, on bank performance.

On the regulators’ side, excessive reliance on systematic adherence to a checklist of regulations and supervisory practices might hamper regulators’ monitoring efforts and prevent a deeper understanding of banks’ risk-taking. More specifically, to shed some light on the aforementioned issues, we aim to answer the following questions: (i) Does compliance with international regulatory standards affect bank operating efficiency? (ii) By what mechanisms does regulatory compliance affect bank performance? (iii) To what extent do bank-specific and country-specific characteristics soften or amplify the impact of regulatory compliance on bank performance? (iv) Does the impact of regulatory compliance increase with level of development?

Building on the IMF and the World Bank Basel Core Principles for Effective Bank Supervision (BCP) assessments conducted from 1999 to 2010, we evaluate how compliance with BCP affects bank performance for a sample of 863 publicly listed banks drawn from a broad cross-section of countries. We focus on publicly listed banks, on the assumption that these institutions are subject to more stringent regulatory controls and compliance requirements. This focus should also enhance cross-country comparability because these banks share internationally adopted accounting standards. Further, we categorize the sample countries by both economic development and geographic region.

Our results indicate that overall BCP compliance, or indeed compliance with any of its individual chapters, has no association with bank efficiency. This result holds after controlling for bank-specific characteristics, the macroeconomic environment, institutional quality, and the existing regulatory framework, and adds further support to the argument that although compliance has little effect on bank efficiency, increasing regulatory constraints may prevent banks from efficiently allocating resources. When only banks in emerging market and developing countries are considered, we find some evidence of a negative relation with specific chapters that relate to the effectiveness of the existing supervisory framework and the ability of supervisors to carry out their duties. However, these results need to be treated with caution, because they may also reflect the inability of assessors to provide a consistent cross-country evaluation of effective banking regulation.