2037. Financial Regulation and Performance: Cross-Country Evidence

James R. Barth, Gerard Caprio, Jr., and Ross Levine
(January 1999)

Those who believe stricter restrictions on allowable bank activities will limit risk-taking behavior may be surprised to learn that in countries where bank activities are restricted, the likelihood of a banking crisis may be greater.

Costly bank failures in the past two decades have focused attention on the need to find ways to improve the performance of different countries' financial systems. Belief is overwhelming that financial systems can be improved but there is little empirical evidence to support any specific advice about regulatory and supervisory reform. With scant cross-country comparisons of financial regulatory and supervisory systems, economists cannot decide how to correct incentives and moral hazard problems in developing economies - whether, for example, to require higher (and more narrowly defined) capital-to-asset ratios, to mandate stricter definition and disclosure of nonperforming loans, to require that subordinated debt be issued, or to install world-class supervision. Proposed reforms usually involve changes in financial regulations and supervisory standards, but many pressing questions about reform remain unanswered.

Making use of a new database, Barth, Caprio, and Levine come up with brief answers to three key questions:

• Do countries with relatively weak governments and bureaucratic systems impose harsher regulatory restrictions on bank activities? Yes.
• Do countries with more restrictive regulatory regimes have poorly functioning banking systems. No- or at least the evidence is mixed.
• Do countries with more restrictive regulatory systems have less probability of suffering a banking crisis? No. In fact, the reverse is true. In countries where banks' securities activities are restricted, the likelihood of a banking crisis is greater, other things being equal.

This paper—a product of Finance, Development Research Group—is part of a larger effort in the group to study the effect of financial regulation and supervision. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Agnes Yaptenco, room MC3-446, telephone 202-473-8526, fax 202-522-1155, Internet address ayaptenco@worldbank.org. The authors may be contacted at gcaprio@worldbank.org or rlevine@worldbank.org. (36 pages)

The full report is available in PDF format.