NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Bank Supervision and Corruption in Lending

"Bank supervisory strategies that focus on forcing accurate information disclosure and not distorting the incentives of private creditors to monitor banks facilitate efficient corporate finance."

Although banks provide a substantial proportion of external finance to enterprises around the globe, there had been no studies of whether international differences in bank supervision influence the obstacles that corporations face in raising external finance. International financial institutions -- such as the Basel Committee, International Monetary Fund, and World Bank -- promote the development of powerful bank supervisory agencies with the authority to monitor and discipline banks. Yet, there is no cross-country evidence to support these recommendations, nor is there evidence on the general question of which bank supervisory policies will facilitate efficient corporate finance.

In Bank Supervision and Corruption in Lending (NBER Working Paper No. 11498), co-authors Thorsten Beck, Asli Demirguc-Kunt, and Ross Levine provide the first assessment of the relationship between bank supervisory policies and the degree to which corruption in lending impedes the ability of firms to raise external finance. Three general theories of government regulation provide a natural framework for understanding the findings of the authors' research.

The first theory holds that strong official supervision of banks can improve their corporate governance. Known as the "supervisory power view," this theory holds that private agents frequently lack the incentives and capabilities to monitor powerful banks. It assumes that governments have both the expertise and the incentives to ameliorate market imperfections and improve the governance of banks.

An alternative theory, the "political/regulatory capture view," argues that politicians and supervisors do not maximize social welfare; they instead maximize their own private welfare. Thus, if bank supervisory agencies have the power to discipline non-compliant banks, then politicians and supervisors may use this power to induce banks to divert the flow of credit to politically connected firms.

Finally, the "private empowerment view" argues that bank supervisory policies should focus on enhancing the ability and incentives of private agents to overcome information and transaction costs, so that private investors can exert effective governance over banks.

The authors' data strongly refutes the view that powerful supervisory agencies with the authority to directly monitor and discipline banks can facilitate efficient corporate finance. Countries with stronger supervisory agencies tend to have firms that face greater obstacles to obtaining bank loans because of corrupt bank officials than firms in countries where the supervisory agency is less powerful.

The results provide some support for the political/regulatory capture view, which emphasizes that powerful supervisory agencies are prone to capture and manipulation by politicians, regulators, or both. Specifically, the authors find that powerful supervisory agencies tend to lower the integrity of bank lending. However, the authors caution that this conclusion needs to be tempered. Powerful supervision is so strongly correlated with poor national institutions (government ineffectiveness, the absence of the rule of law, high national corruption) that it is difficult to identify an independent relationship between supervisory power and bank corruption when controlling for these institutional traits.

Finally, the authors' findings are consistent with the private monitoring view. In particular, bank supervisory strategies that focus on forcing accurate information disclosure and not distorting the incentives of private creditors to monitor banks facilitate efficient corporate finance. These findings are consistent with approaches that simultaneously recognize that private agents face substantive information and enforcement costs when monitoring banks, while also recognizing that politicians and regulators will act in their own interests and not necessarily act to reduce market frictions. Private monitoring exerts a particularly beneficial effect on the integrity of bank lending in countries with sound legal and bureaucratic institutions.

The authors use firm-level data from the World Business Environmental Survey on more than 2,500 firms across 37 countries to examine the impact of bank supervision on the obstacles firms encounter in raising external capital. As they point out, bank supervision clearly matters. Bank supervisory policies that ameliorate market failures by forcing the accurate disclosure of information reduce the obstacles that firms face in raising external finance. Active bank supervision can help ease information costs and improve the integrity of bank lending. However, the authors' findings suggest that powerful supervisory agencies too frequently do not act in the best interests of society

-- Les Picker


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