Financial Regulation and Performance: Cross-Country Evidence

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 non-performing 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, the authors 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.