Rethinking Bank Regulation: Till Angels Govern
James R. Barth, Senior Fellow, Milken Institute
Gerard Caprio, Jr., Director for Policy, World Bank
December 8, 2005
Milken Institute Conference Center
Santa Monica, CA

After six years of research that involved two in-depth surveys, hundreds of questions, painstaking cross-checking of data and exhaustive follow-up, James Barth and Gerard Caprio realized there is tremendous diversity in banking supervisory and regulatory practices around the world.

This made answering the question, "Which banking system works best?" all the more important.

How much diversity did they find? Examples:

Does the size of a country's banking system matter? In Germany, bank assets represent 361 percent of GDP, while in the U.S. it's 64 percent and in Sudan only 14 percent.

Does government ownership of banks matter? In China, 98 percent of the banking assets are government owned, while in India, the government owns 75 percent. In the U.S., the government owns no banks.

Does the amount of assets in foreign banks matter? In Italy, only 6 percent of banking assets are foreign-owned, while that number is 19 percent in the U.S. and 99 percent in New Zealand.

In addition, Barth and Caprio said, each country's regulatory system is different. For instance, half of the 152 countries they and colleague Ross Levine surveyed have explicit deposit insurance policies, while the other half none. Restrictions on the activities in which banks may engage differ country by country. So do the supervisory powers in each country.

So given all of these differences, what system works best? What rules and regulations should countries adopt to ensure the most efficient banking system?

Barth, Caprio and Levine — authors of a new book, Rethinking Bank Regulation: Till Angels Govern, which is based on their research — found that:

  • Open, competitive, democratic political institutions foster private monitoring and transparency. These countries are less likely to limit bank entry and activities and are less likely to have state banks.
  • Closed, uncompetitive, autocratic political systems do not favor transparency. These countries limit bank entry and activities and tend to have state banks.

Based on their research, Barth and Caprio said, they reached the following conclusions:

  • Countries should avoid relying on bank-activity restrictions, stringent official powers and state ownership.
  • They should emphasize private monitoring and avoid generous deposit-insurance schemes.
  • They should foster/force information disclosure.

Most important, they said, supervisors have a crucial role in governing the financial system, but governments should support market discipline, not supplant it with intrusive regulation and supervision.

"It's the private sector's ability to monitor that matters more to the health of the banking system (than supervision)," Caprio said.

Finally, they said, no one size fits all. Given the complexities of each country's economic, legal and political systems, and their individual conditions and needs, there is no simple set of "best practices" to banking regulation in countries around the world.

Does this all matter? Of course, Barth said. "A stable and well-functioning banking system is critical for economic growth and development."

James R. Barth is a Senior Fellow at the Milken Institute and the Lowder Eminent Scholar in Finance at Auburn University. He also has been professor of economics at George Washington University, associate director of the economics program at the National Science Foundation, and Shaw Foundation Professor of Banking and Finance at Nanyang Technological University. Barth was an appointee of Presidents Ronald Reagan and George H.W. Bush as chief economist of the Office of Thrift Supervision, and previously as chief economist of the Federal Home Loan Bank Board. Most recently, he served as leader of an international team advising the People's Bank of China on banking reform.

Gerard Caprio, Jr. is director for policy in the Financial Sector Vice Presidency at the World Bank, and is Professor of Economics at Williams College. Previously he was manager, Financial Sector Research, in the bank's Development Research Group. He is the World Bank's senior spokesperson on financial markets and financial sector regulation, development and reform. Before joining the bank in 1988, Caprio was vice president and head of global economics at JPMorgan, and previously held economist positions at the Federal Reserve Board and the IMF, and taught at George Washington University.