London school of commerce

(Business School)

INVESTMENT MANAGEMENT AND

CAPITAL MARKETS

(RESEARCH METHODS)

CRITICAL REVIEW

THE
RELATION BETWEEN BANK REGULATIONS
&
ECONOMIC PERFORMANCE:
A CROSS-COUNTRY ANALYSIS

Module Leader: VIJAY SHENAI AND MAKAILLA McConnell

ID No: 0661SWSW1109

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The papers under review discuss the relation between national wealth and

bank regulatory policy, and all the data measured by three pillars of the new

Basel capital accord. In this article, using the database of 153 countries

reflects that the countries with great monitoring, accounting practice, financial

transparency, and credit rating efficiency are associated with greater wealth

and less risk. The title of topic is The Relation between Bank regulation and

Economic performance: A cross- country analysis. This article has been

written by Mark Bertus, John S Jahera Jr, and Keven Yost.and published

banks and bank system in 2007 volume 2 issues 3.

Purpose & understanding of the paper & Placement

of article within wider subject context
Barth, Caprio and Levine BCL (2006) prepared a questionnaire with 262

questions and distributed to central banking authorities of 153 countries. This

information represents the official government position, annual GDP, GDP

growth rate, inflation rate for 2000- 204. All this data collected from the World

Bank. They also gather the information related corruption and democracy

from La portal, Lopez-de-Silages, Shelter and Vishnu (1999). BCL evaluated

the relationship of these factors with financial sectors of the country.

It is an inclusive research paper which has been divided into 5 sections,

Section 1 introduction

Section 2 Review of selected literature on Basel II pillars

Section 3 Data, Methodology, and Descriptive Statistics

Section 4 discusses the empirical results,

Section 5 concludes

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According to Bertus, Jahera and Yost, Global financial markets are a

fundamental ingredient in the production and maintenance of the world's

economic activity. Overall financial condition improve the economic

performance applying five broad functions (see Levine, 2005, p. 4)

• 1 The production of ex ante information about investments.

• 2 The monitoring of investments for which they provide financing.

• 3 The facilitation of risk management and diversification.

• 4 Mobilizations and pooling of resources.

• 5 The facilitation of trading goods and services.

Bertus, Jahera and Yost argue that banking system is the most important

factors of financial market. And it is widely acknowledged that a well

structured banking system, defined by its supervisory practices, risk taking,

and governance, promotes greater financial performance and economic

stability. Further they say that Differences with respect to corruption, democracy,

and legal origin, for example, create heterogeneous regulatory environments

that impede the implementation of universally effective policies. The intent of

this study is to empirically evaluate the association between a country's

banking system characteristics and its overall level of income and income

growth.

Paper show identify that over the past two decades most of all financial

market facing financial crisis and which leaves the negative effects on

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economic condition around the world. And writers argue that the main cause

of these can be unsound banking practices, such as shifting toward non-

traditional business revenue or increasing the risk profile of loans. About the

risk factors, to develop tools and insights that allow supervisors and market

participants to assess banks' risk profiles and risk management measures

more accurately, the supervisors and regulators around the world are

switching from traditional financial ratio analysis to risk-based supervision.

And through this efficient allocation of finance resource would be possible.

Bertus, Jahera and Yost also evaluate the new recommendation from Basel

Committee in the sense of relation between bank regulation and economic

performance. Basel committee has listed three pillars which known as The

New Basel Capital Accord (Basel II). Basically these pillars are the criteria to

evaluate the banking system and practice. Among the three pillars the first

two pillars of Basel II emphasize the importance of improved policies for

capital regulation and supervisory practices. The third pillar addresses an

emerging emphasis on market discipline through better information

disclosure.

Under the guidance of recommendation designed the Basel Committee are

designed to improve banking practices Bertus, Jahera and Yost specify an

empirical model to examine the relation between each of the three pillars of

the Basel II Accord and income and risk under the hypothesis that they are

positively related to income and inversely related to risk. Using a dataset

covering 153 countries that controls for various country-specific factors, we

find that the level of information disclosure is positively related to national

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income and inversely related to changes in national income. In addition, we

find that capital regulatory oversight and supervisory oversight seem to have

no influence on economic activity.

To make their arguments clear writers reviewed the literature on Basel II

pillars. They found out that the Productive economies are typically

characterized by financial systems that facilitate information flow to promote

efficient monitoring, governance, and the allocation of capital. And if the cost

of the acquiring and interpreting information is high then it become problem

able for the investor to evaluate firms, managers, and market conditions

before making investment decisions (Levine, 2005). ). As a result, investors

who are averse to large amounts of risk may be unwilling to invest their funds

in activities that have the highest values.

Bertus, Jahera and Yost quoted Boyd and Smith, 1992; Delong, 1991; and

Lamoreaux, 1995 and say that bank Banks and other financial intermediaries

are major financial system components. By pooling savings from different

individuals, banks transform this capital by channeling it to valuable

investments. Before they procure these savings, however, banks must first

convince individuals of the bank's ability to make sound investments. By

quoting Diamond, 1984 and De La Fuente and Marin, 1996 writer argue that

That is, banks, when lending to firms, become important monitors of

managers and their operations and may be better suited to finding innovative

activities that lead to greater overall wealth.

The focus of current research has shifted toward improving the managerial

and supervisory decisions for allocating bank capital. Basel II has provided

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three recommendations, national differences in economic policy; political

structure, legal origin, and culture make the implementation of universal

guidelines challenging (Berth et al., 2004). And research has shown that legal

origin impacts the extent to which firms seek financing from banks, rather than

capital markets, as well as the relation between economic development and

finance system structure.

Bertus, Jahera and Yost have specified that Barth, Caprio and Levine (BCL)

find a positive relation between bank development and the strength of a

country's capital regulatory policy. And other research done by (Santos, 2001;

Koehn and Santomero, 1980; Kim and Santomero, 1988; Besanko and

Kanatas, 1996; and Blum, 1999) suggests that more stringent capital

requirements may not reduce the risk-taking behavior of banks. So according

to writers BCL report mixed evidence on the relation between capital

regulation and bank stability. In addition, they find supervisory oversight is

positively related to bank development, even when controlling for country-

specific features.

According to Bertus, Jahera and Yost the final pillars of Basel II is most

important because characterized the market discipline and that attitude

generate the value for the firm. The governance of banks makes bank

managers more accountable. This should result in an increased ability of firms

• To borrow funds

• a more optimal allocation of capital

• monitoring of a bank's investments

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Further they added that the accurate and reliable information about financial

market is essential for maintaining market discipline. And the aspects those

improve the reliability and quality of the database related firm are

• Accounting standards

• External auditing

• Transparency

• Credit ratings

RESEARCH METHOD USED IN THIS STUDY:

Bertus, Jahera and Yost have carried out quantitative and quantitative

research based on theories, numerical data, Descriptive Statistics and

hypotheses. To considering the relation between Bank regulation and

economic performance, they have observed and analysis the theatrical and

numerical work done previously about subject by BCL with the conjunction of

World Bank. And argue that all the data are most broad and country-level data

currently available of global banking systems.

Writers quoted the BCL and define that BCL surveyed 152 countries with 263

questions. And in addition they conducted number of indices which coved the

answers of the related questions and all this indices evaluate the element of

• Regulation and governance within county

• Capital requirements

• Supervisory power and independence

• Information disclosure

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Bertus, Jahera and Yost used the earnings management and timing

hypotheses to observed increase in performance and argue that their

analysis shows the relevance measures of economic performance in each

country (GDP and GDP growth) with variable measuring each of the three

pillars of Basel II as well as control for economic condition and political

economy.

Economic performance = α +β1 Basel II + β2 Economy + β3 Political + ε

In equation, the three Basel II pillars of capital regulatory oversight,

supervisory oversight and market discipline are represented by the Basel II

vector. The recommendation for capital regulatory oversight suggests that

banks hold various degrees of verifiable capital relative to their risk profiles.

The second pillar of the Basel Accord focuses on the ability of a country's

banking authority to exert control over banks in its market. About third pillars

Measuring the level and quality of the third pillar, market discipline, is more

challenging. To investigate this factor, they have created a market information

index using three elements that measure the reliability and existence of

information reported to a banking market.

To describe the importance and relation of these components in explaining

the degree of information disclosure table given below shows that all three

components are positively and significantly correlated with each other,

suggesting that countries with more bank specific disclosures are also, on

average, audited more by both domestic and international credit ratings.

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Bertus, Jahera and Yost have explained descriptive statistics which offers

statistics for variables and indices.

Looking at the three pillars of the Basel II Accord, there are no statistical

differences among the levels of the capital regulatory index, supervisory

power and supervisory independence across income levels. For the capital

regulatory index, the median country in the overall sample and in each

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quartile has an index of 6, except the upper middle income countries.

Similarly, no monotonic relation exists between supervisory power and

income or supervisory independence and income. Moreover, the market

information index is monotonically decreasing with income, which indicates

that lower income countries have less information disclosure, on average,

than more affluent countries.

Table also shows a non-monotonic relation between GDP growth and level of

income, and the same is true for average inflation. Both GDP growth and

average inflation increase as one move from high income countries to upper

middle income countries. Both decrease as income decreases between the

lower two quartiles. It illustrates some interesting differences in political

demographics for low and high income countries and the levels of the

corruption and democracy indices decrease as income decreases.

SUGGESTIONS FOR IMPROVEMENT

Bertus, Jahera and Yost have carried out good research to find out

relationship between bank regulation and economic performance. They have

collected qualitative source of information like research of BCL and other

writers and also from Basel Committee some banking authorities from all over

the world. They also demonstrate their research very well with tables and

numeric information.

The weak side of this research is writers have used maximum secondary data

gathered from previous research done by other on same subjects. Further

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writers have used guideline provide by Basel committee describing capital

regulatory and supervisory oversight but they also admit that there is no direct

evidence on how regulatory guidelines and policy for domestic banking

systems affect the economic performance of a country.

For the improving the research paper writers would collect primary data by

doing surveys regarding subjects. They can also use internet to collect more

up dated information, interview of the different financial authority would gives

more relevant and qualitative information.

RELIABILITY & VALIDITY OF THE FINDINGS

In the point of view of the research method adopted and the approach used to

find out relationship between bank regulation and economic performance: a

cross-country analysis. Finding of the paper appear to be consistent over time

and accurate representation of association of national wealth with bank

regulation policies and measured by three of the new Basel capital accord.

From the results, findings can be referred to as reliable and can be

reproduced under the similar methodology

As far as validity of the findings in the paper is concerned it is obvious that the

research truly measures that which it was intended to measure.. On the paper

by using theatrical, numerical and statistical information, Bertus, Jahera and

Yost have proved that well functioning financial system promote the financial

development within countries and have effectively found the intention of

research. As on the basis of concussion and implication of paper it can be

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said that finding in the article is reliable and valid because it is free from

persuasion in the language in the paper.

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