NBER Reporter: Spring 2000

Prudential Supervision

An NBER Conference on "Prudential Supervision: What Works and What Doesn't," organized by NBER Research Associate Frederic S. Mishkin of Columbia University, took place on January 13-15. The program was:

James R. Barth, Auburn University, Gerard Caprio, Jr., World Bank, and Ross E. Levine, University of Minnesota, "Banking Systems Around the Globe: Do Regulation and Ownership Affect Performance and Stability?"
Discussant: Mark Gertler, NBER and New York University

Allen N. Berger, Federal Reserve Board of Governors, Margaret K. Kyle, MIT, and Joseph M. Scalise, Bain & Company, "Did U.S. Bank Supervisors Get Tougher During the Credit Crunch? Did They Get Easier During the Banking Boom? Did it Matter to Bank Lending?"
Discussant: Stephen G. Cecchetti, NBER and Ohio State University

Randall S. Kroszner, NBER and University of Chicago, and Philip E. Strahan, Federal Reserve Bank of New York,

"Obstacles to Optimal Policy: The Interplay of Politics and Economics in Shaping Banking Supervision and Regulation Reforms"
Discussant: Jeremy C. Stein, NBER and MIT

Mark Carey, Federal Reserve Board of Governors, "Dimensions of Credit Risk and Their Relationship to Economic Capital Requirements"
Discussant: Patricia Jackson, Bank of England

Robert R. Bliss, Federal Reserve Bank of Chicago, and Mark J. Flannery, University of Florida, "Market Discipline in Governance of U.S. Bank Holding Companies: Monitoring versus Influencing"
Discussant: Raghuram G. Rajan, NBER and University of Chicago

Charles W. Calomiris, NBER and Columbia University, and Andrew Powell, Central Bank of Argentina, "Can Emerging Market Bank Regulators Establish Credible Discipline? The Case of Argentina, 1992-9"
Discussant: Douglas W. Diamond, University of Chicago

Joe Peek, Eric S. Rosengren, and Geoffrey M. B. Tootell, Federal Reserve Bank of Boston, "Synergies Between Bank Supervision and Monetary Policy: Implications for the Design of Bank Regulatory Structure"
Discussant: Ben S. Bernanke, NBER and Princeton University

Barth, Caprio, and Levine collect cross-country data on commercial bank regulation and ownership in more than 60 countries and evaluate the links between their different regulatory/ownership practices and financial sector performance and banking system stability. They find substantial variation across countries in three areas: regulatory restrictions on the ability of commercial banks to engage in securities, insurance, and real estate activities; the mixing of banking and commerce, both in terms of regulations on commercial banks owning nonfinancial firms and vice versa; and the degree of state ownership of commercial banks. Overall, they find that imposing regulatory restrictions has negative implications for the performance of commercial banks. Specifically, regulations that restrict the ability of banks to engage in securities activities and own nonfinancial firms are closely associated with greater instability in the banking sector. They find no countervailing positive benefits from restricting the mixing of banking and commerce or from restricting the activities of banks in the areas of investment banking, insurance, and real estate.

Berger, Kyle, and Scalise investigate the possibility that overall changes in supervisory "toughness" may significantly affect bank lending behavior and may potentially affect macroeconomic or regional economic health. They use information on the supervisory process, confidential data from bank examinations, and bank balance sheet and income data for 1986-98. They find that any increase in supervisory toughness during the credit crunch period (1989-92) likely had only a small effect on bank lending behavior, but decreases in supervisory toughness during the boom period (1993-8) may have increased bank lending significantly.

Kroszner and Strahan provide a positive political economy analysis of the most important revision of the U.S. supervision and regulation system during the last two decades, the 1991 Federal Deposit Insurance Corporation Improvement Act (FDIClA). They analyze the impact of private interest groups and political-institutional factors on the voting patterns on amendments to FDICIA and its final passage in order to determine the importance of different types of obstacles to welfare-enhancing reforms. They find that both private interest group and political-institutional factors play significant roles; a "divide and conquer" strategy appears to be effective in bringing about legislative change.

A major revision of international bank capital regulations now being proposed would embody recent advances in credit risk measurement and management. Previous regulations have been simpler, primarily aimed at getting capital requirements right on average, and thus largely ignoring the difference between average and marginal. Carey presents evidence showing the importance of the new regulations' explicit treatment of several important dimensions of credit risk. If such dimensions are compressed or ignored, capital arbitrage activities by banks are likely to continue, leading to an increase in bank failure rates over time.

Bliss and Flannery note that effective market discipline involves two distinct components: the ability of security holders to accurately assess the condition of a firm (monitoring) and the ability to have their assessments reflected in subsequent actions by management (influence). There is substantial evidence for the existence of market monitoring, but little existing evidence on market influence. Bliss and Flannery find that security price changes have no influence on subsequent managerial actions. The statistical linkages between security returns and subsequent management actions are consistent with monitoring, but not influence. They conclude that, for the moment, market discipline per se remains a matter of faith and not evidence.

In the early 1990s, after decades of high inflation and financial repression, Argentina embarked on a course of macroeconomic and bank regulatory reform. Bank regulatory policy promoted privatization, financial liberalization, free entry, and limited safety net support, and it established a novel mix of regulatory and market discipline to ensure stable growth of the banking system during the liberalization process. Argentina suffered some fallout from the Mexican tequila crisis of 1995, but its response to that crisis (allowing weak banks to close) and the redoubling of regulatory efforts to promote market discipline after the crisis made Argentina's banking system quite resilient during the Asian, Russian, and Brazilian crises. Argentina's bank regulatory system is now widely regarded as one of the two or three most successful examples among emerging market economies. Calomiris and Powell trace the evolution of Argentina's regulatory policy changes of the 1990s and show that the reliance on market discipline as part of the regulatory process played an important role, encouraging proper risk management by banks.

Previous research has shown that confidential supervisory information can improve macroeconomic forecasts of inflation and unemployment rates, two variables critical for the conduct of monetary policy. Thus, synergies between monetary policy and bank supervision could be an important consideration for determining the regulatory structure of bank supervision. Data about the set of institutions currently supervised by the Federal Reserve System provide information that can substantially improve Fed forecasts. However, Peek, Rosengren, and Tootell find that the most useful information comes from the data on state-chartered banks. If regulatory structure were to be based on which institutions provide the greatest synergies for monetary policy, then the set of banks supervised by the Federal Reserve System would be quite different from those currently under its regulatory structure.

These papers and their discussions will be published in an NBER Conference Volume by the University of Chicago Press. The volume's availability will be announced in a future issue of the NBER Reporter. These papers can be found at Books in Progress

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