Finance VIII

UPDATE: below

Increased banking regulation is populist, popular, and about to pass -- despite little evidence of effectiveness.

There's various national regulators but, for years, banking oversight in the most advanced countries has reflected the Basel Accords (Basel I principles were widely adopted; Basel II rules mostly are effective in the 13 countries on the Basel committee, including the United States and Europe). The Basel "Core Principles" (BCPs, revised in 2006) for bank supervision include "capital adequacy," "risk management," and "accounting and disclosure." Together, they were "hailed as a milestone on the road towards global financial stability [and] are supposed to be a guideline for prudent banking regulation."

So, has Basel worked? Two international economists -- Asli Demirgüç-Kunt (World Bank) and Enrica Detragiache (IMF) -- recently studied whether compliance with Basel matters (at 3):

In light of the recent crisis and the resulting skepticism about the effectiveness of existing approaches to regulation and supervision, it is natural to ask if compliance with the global standard of good regulation is associated with bank soundness. This is the subject of this paper. Specifically, we test whether better compliance with BCPs is associated with safer banks.

The surprising answer (at 4):

All in all, we do not find support for the hypothesis that better compliance with BCPs results in sounder banks as measured by Z-scores [the number of standard deviations by which bank returns have to fall to wipe out bank equity]. This result holds after controlling for the macroeconomic environment, institutional quality, and bank characteristics. We also fail to find a significant relationship when we consider different samples, such a sample of rated banks only, a sample including only commercial banks, and samples including only the largest financial institutions. In an additional test, we calculate aggregate Z-scores at the country level to try to capture the stability of the system as a while rather than that of individual banks, but also this measure of soundness is not significantly related to overall BCP compliance.

Indeed, the authors found (at 5) "that stronger compliance with principles related to the power of supervisors to license banks and regulate market structure are associated with riskier banks."

As Handelsblatt's international economic correspondent Olaf Storbeck observes:

The result casts doubt on the current principles guiding financial regulation. There is no evidence that complying to the Basel rules is correlating with sounder banks. The same is true when the researcher focus on the stability of the entire banking system in spite of individual banks. These results also hold when the macro economic environment of a country is taken into account, as well as the quality of the political and economical institutes and various bank characteristics like the size and its customer base. . .

These conclusions are appalling, especially in light of the ongoing discussions on the future reforms of banking regulation. Obviously not everything that appears reasonable from a theoretical perspective lives up to the expectations. The study impressively reveals how little economists do know about the effects of current banking regulation.

In that light, it's significant that the same authors reached the opposite conclusion in 2008, relying on pre-meltdown data. EconLog's Arnold Kling finds the new analysis particularly persuasive:

This is an unusual sort of paper, in that it tries to look for evidence that regulation works. Ordinarily, economists proceed directly from the observation that market results are imperfect to the conclusion that regulation is the solution. Faith-based regulation, as opposed to evidence-based regulation.

Because we over-estimate the ability of bureaucrats to out-perform markets, the former is exactly what Congress and the Administration are poised to pass.

MORE:

Blogger Assistant Village Idiot commenting on a different post:

The choice is never between good regulation and corporate bandits allowed to run wild. It is a choice between our current regulation -- mixed at best -- and some new regulation -- mixed at best.

It is the descendant of the marxist argument that communism would work well if only it were tried properly with the right people. But any form of government works well such conditions - even tyranny. What sets free markets and free governments apart is that they work reasonably well even under bad conditions. They are a damage-limiting strategy in a world of imperfect people. As we will always have some bad conditions in this fallen world, that's the point.