DO REGULATIONS AFFECT BANKING PERFORMANCE?

GOVERNMENT GOVERNANCE MAY MATTER

CHUNG-HUA SHEN and YUEN-HSIANG CHANG*

The authors study the impact of restrictions on commercial banks’ engagement in

securities, insurance, and real estate, as well as a mix of banking and commerce. The
model specifies the impact as a function of government governance (the rule of law),
which allows the authors to investigate two conflicting hypothesis, i.e., the restriction-
enhancing hypothesis and facility-supporting hypothesis. The former effect suggests
that good governance enhances the hypothesized adverse effect of restrictions, and the
latter suggests that good governance mitigates this adverse effect. The study clearly
demonstrates that restrictions on commercial banks’ right to engage in securities
and insurance, along with restrictions on the mixing of banking and commerce,
reduce bank profits. However, good governance mitigates such an adverse impact,
i.e., the facility-supporting hypothesis is supported. Restrictions on real estate, on
the other hand, seem to have positive effects on bank profits. The results are robust
to different specifications. (JEL G21, G28)

I. INTRODUCTION creates greater diversity, thereby augmenting

Studies of optimal financial systems have re-
cently attracted wide attention. One of the ma-
jor issues is whether the authority should allow
commercialbanks (hereafter, ‘‘banks’’) to engage
in financial-related and other non-financial ac-
tivities, where the former are made up of secu-
rities, insurance, and real estate, and the latter
comprise a mix of banking and commerce.
Those who favor limiting commercial banks
to merely ‘‘traditional’’ deposit taking and loan
making argue that inherent conflicts of interest
arise when banks engage in the above financial
and non-financial activities. Expanding the ar-
ray of permissible activities, they may provide
greater opportunities for moral hazard, which
in turn may distort banks’ investment deci-
sions, especially when they operate within a de-
posit insurance system (Boyd et al., 1998).
Those who advocate substantial freedom
with respect to commercial banking activities
alternatively argue that ‘‘universal’’ banking
*The authors thank Tai-Hsin Huang and two anony-
mous referees for helpful comments.
Shen: Department of Money and Banking, National
Chengchi University, Mucha, Taipei, Taiwan. Phone
886-2-2939-3091-81020, fax 886-2-2939-8004, E-mail
chshen@nccu.edu.tw
Chang: Department of Money and Banking, National
Chengchi University, Mucha, Taipei, Taiwan. E-mail
s750412@yahoo.com.tw
the profits of banks.1
Furthermore, these proponents of the lift-
ing of restrictions suggest that the often-
claimed conflict of interest does not exist when
banks engage in securities. Krosner and Rajan
(1994) and Puri (1996) share similar views.
Kwan (1997) states that because of a low cor-
relation between banks and securities, a bank
should be able to diversify its risk by engaging
in security activities. White (1986) studies the
securities activities of national banks before
the Glass-Steagall Act and finds that the mean
and variance of the return to securities affili-
ates were higher than commercial banks,
and that their return correlation was close
to zero. Along the same lines, Barth et al.
(1998) indicate that in countries in which
banks face restrictions vis-à-vis engaging in
securities, the likelihood of a banking crisis is
greater. Santomero and Babbel (2001) recently
reported that a bank’s selling of insurance
products can substantially reduce its costs.2
1. Universal banking here means that banks can en-
gage in conventional commercial banking businesses, such
as deposits and loans, as well as investment activities (see
Smith and Walter, 1997).
2. More evidence can be found. Benston (1990) dem-
onstrates that when a combination of commercial and
investment banking is permitted, bank failures are lower,
indicating that profits are higher and risks are lower. Lown
et al. (2000) also indicate that the largest benefits from
diversification result when bank holding companies are
combined with life insurance firms.

92
Contemporary Economic Policy (ISSN 1074-3529) doi:10.1093/cep/byj013
Vol. 24, No. 1, January 2006, 92–105 Ó Western Economic Association International 2005
Advance Access publication November 16, 2005 No Claim to Original U.S. Government Works
 SHEN & CHANG: DO REGULATIONS AFFECT BANKING PERFORMANCE?
Some opponents to lifting the firewall be-
tween banks and securities make the claim that
doing so may increase banking risks. Boyd
et al. (1993) find that simulations of U.S. bank
holding companies merging with life insurance
and property/casualty insurance firms may re-
duce risks, but that mergers with security firms
would likely increase risks. Surveying over
sixty countries on the three financial-related
activities (securities, insurance, and real estate)
and one non-financial activity (a mix of bank-
ing and commerce) that banks are allowed to
engage in, Barth et al. (2000) score each activ-
ity from 1 to 4, with a higher number denoting
tighter restrictions. They employ the average
of 1990–1995 bank data across about 60
countries to investigate the impact of these re-
strictions on financial (bank and securities) de-
velopment and industrial competition. They
do not, however, find a reliable statistical re-
lationship between regulatory restrictions on
financial development and industrial competi-
tion. Barth et al. (1998, 2002) also show that
countries with more restrictive regulations on
average have a larger net interest margin
(NIM).
This article investigates how government
governance (hereafter, governance) affects
the impacts of the restrictions on bank per-
formances. This article is in a manner similar
to that of Barth et al. (2000), but focuses on the
role of governance. The authors provide two
conflicting arguments regarding how good
governance affects the impacts of the restric-
tions. The first is the restriction-enhancing
hypothesis. That is, when government imposes
the restrictions on bank activities, good gover-
nance makes this restriction effectively imple-
mented. As a result, restrictive effects are
further enhanced.
The authors next claim that there is a
facility-supporting hypothesis, which argues
that a good government will provide a good
supporting environment to compensate its
restrictions on banks’ activities. Hence, while
a government restricts the activities of banks
for the sake of, say, reducing risk, it knows
that these restrictions may also hurt the
possibility of diversification, which in turn
increases the risk of banks. Thus, it provides
other supporting facilities, such as tax deduc-
tions, to mitigate the unfavorable impacts
of the restrictions. Hence, this hypothesis
claims that while restrictions per se may
be detrimental to bank performance, good
93
governance should lessen, to some extent,
the adverse impact.
In order to test their hypothesis, the authors
constructed the interaction variable between
the governance index and the degree of restric-
tion. This allows them to identify not only the
manner in which restrictions influence bank
performance, but also the channel the influen-
ces take. The governance index, which is taken
from La Porta, Lopez-de-Silanes, Shleifer,
and Vishny (hereafter, LLSV) (1998), is an
average of the efficiency of the judicial system,
the (narrowed) rule of law, the corruption,
the risk of expropriation, and accounting
standards. It is expected that a country with
a good governance index should have more
creditability and less corruption, which may
or may not improve banks’ performance when
these banks are restricted with regard to en-
gaging in the various activities.3
The U.S. banking system may be employed
to illustrate the importance of this motivation.
A well-known fact is that banks in the U.S.
were limited from engaging in financial-
related activities before November 12, 1999,
the date the U.S. passed the Gramm-Leach-
Bliley Financial Services Modernization Act
(hereafter, GLB Act).4 As a consequence, an
unfavorable impact on bank performance
arising from the restrictions should have been
expected. However, banks’ performance in the
U.S. was instead found to be among the best in
the late 1990s. To reconcile these phenomena,
competition among banks and the booming
economies during the late 1990s could be re-
sponsible for this good performance, on the
one hand, while good governance in the U.S.,
on the other, may also contribute to the good
performance. The evidence may thus be con-
sistent with the authors’ facility-supporting
hypothesis.
3. While Barth et al. (2000) also consider the gover-
nance index, they do not use the interaction effect between
the governance and the restrictions.
4. The U.S. case is designated as a limited but not re-
stricted one in Barth et al. (2000), probably because of the
following reasons. Beginning in 1987, the Federal Reserve
authorized bank holding companies to establish securities
subsidiaries, the so-called ‘‘Section 20 subsidiaries,’’ to
engage in limited underwriting and dealing of municipal
revenue bonds, mortgage-related securities, consumer-
receivable securities, and consumer paper. The revenue
from the above bank-ineligible securities activities could
not exceed 5% of the securities subsidiary’s total revenues
in order to comply with the Glass-Stegall Act. The ‘‘limits’’
were gradually lifted up to 10%, 15%, and the current 20%
(see Kwan, 1997, for details). Hence, the securities activ-
ities are limited only.
94 CONTEMPORARY ECONOMIC POLICY
The authors use bank-specific 1995–1999
data to explore this issue.5 The 46 sample coun-
tries are selected based on La Porta et al. (1998),
which are similar to those selected in Barth
et al. (2000). Both OLS and the random effects
model for panel data are employed to estimate
the model. Similar to the results reported by
Barth et al. (2000) that the restrictions are
unfavorable to banks’ performance, however,
the new finding here is that good governance
lessens the adverse impacts. As a result, the
facility-supporting hypothesis is supported.
To examine the robustness of the hypothesis,
the authors also divide their sample into low-,
medium-, and high-income countries. It is
found that the results are reliable for high-
income countries when banks are allowed to
engage in securities, but not when banks have
the right to engage in other financial-related
and non-financial activities. High-income
countries are also affected more by the restric-
tions than the low-income countries. The
authors also add the governance variable as
an extra independent variable in addition to
the interaction between the governance index
and the restriction index. The coefficient of
this extra variable, however, is not significantly
different from zero, but the interaction terms
remain significant. Otherwise, banks in some
countries display extremely high positive
ROAs, which are unusual in theory. The
authors use the following two methods to in-
vestigate the robustness of the results. First,
these high ROA banks are dealt with as outliers
and are removed from the data. The authors
find that results do not change qualitatively af-
ter the outliers are removed. Because the bank-
ing industry is a high leverage industry, the
authors next remove banks in each country
with a lower leverage from the data to examine
the robustness. The authors find that results do
not change qualitatively. Finally, banks in the
U.S. have been allowed to engage in limited
security business transactions since 1987. It
may thus cast some doubts about the validity
of the restriction index regarding the U.S.
case. The authors thus remove the U.S. banks
and investigate the robustness of the results.
As can be seen, results do not change, and
the conclusion holds true.
5. The authors do not use five-year average data as
Barth et al. (2000) do. The use of five-year averages can
eliminate possible earnings management (window dress-
ing) made by banks, but does lose detailed bank individual
information, to some extent.
Section 2 of the article defines the econo-
metric specifications. Section 3 provides the
data sources, compares the basic statistics of
46 countries, and classifies them on the basis
of the restriction indices. Section 4 reports
the estimated results, while section 5 presents
the concluding remarks.
II. ECONOMETRIC METHOD
Banks’ performance is proxied by the
ROA (return on asset), which denotes
a bank’s profit. The restrictive index variables
are IBANK S , IBANK I , IBANK R , and IBANK N : The
term LEVER is the proxy for the leverage,
LIQUIDITY is the proxy for the liquidity risk,
MANAGE is the proxy for the management ef-
ficiency, L/D is the proxy for loan policy, and
BURDEN is the burden ratio. The term CR3 is
the bank concentration ratio calculated from
the three largest banks, GDPper is the GDP
per capita, EXCH is the percentage change
in the exchange rate, RATE is the nominal de-
posit rate, and INFLA is the inflation rate.
The authors’ econometric model involves
a conventional OLS and the random effects
model with coefficients of the impacts being
a function of the governance index.
ð1Þ ROAijt ¼ h0ij þ h1 IBANK Si
þ h2 IBANK Iiþ h3 IBANK Ri
þ h4 IBANK Ni þ a1 LEVERijt
þ a2 LIQUIDITYijt
þ a3 MANAGEijt þ a4 L=Dijt
þ a5 BURDENijt þ b1 GDPperit
þ b2 EXCHit þ b3 RATEit
þ b4 INFLAit þ b5 CR3it þ eijt
and
h1 ¼ /11 þ /12 Gi
h2 ¼ /21 þ /22 Gi
h3 ¼ /31 þ /32 Gi
h4 ¼ /41 þ /42 Gi
i ¼ 1; . . . ; C; j ¼ 1; . . . ; Bi ; t ¼ 1; . . . ; T ;
where C is the number of countries (46 here),
Bi is the number of banks in country i, and
T is the time span (1995–1999, annual data).
 SHEN & CHANG: DO REGULATIONS AFFECT BANKING PERFORMANCE?
The subscripts i, j, and t will be omitted for the
sake of brevity.
Equation (1) is made up of three categories
of explanatory variables. The first consists of
the restrictive index variables, namely IBANK S ,
IBANK I , IBANK R , and IBANK N : These indices
are taken from Barth et al. (2000), who mea-
sure the degree to which national regulatory
authorities allow commercial banks to engage
in the following three ‘‘non-traditional’’ activ-
ities. Term IBANK S is the ability of commercial
banks to engage in the business of securities
underwriting, brokering, dealing, and all
aspects of the mutual fund industry; IBANK I
is the ability of banks to engage in insurance
underwriting and selling; IBANK R is the ability
of banks to engage in real estate investment,
development, and management; and IBANK N
is the degree of regulatory restrictions on
the mixing of banking and commerce.
The four indices measure the degree of
regulatory restrictiveness for each activity
from 1 to 4, with larger numbers representing
greater restrictiveness. The definitions of the 1
through 4 designations are as follows. For 1, it
denotes the unrestricted case, i.e., a full range
of activities in the given category can be con-
ducted directly in the commercial bank; for 2,
it is permitted, i.e., a full range of activities can
be conducted, but all or some must be con-
ducted in subsidiaries; for 3, it is restricted,
i.e., less than a full range of activities can be
conducted in the bank or subsidiaries; for 4,
it is prohibited, i.e., the activity cannot be con-
ducted in either the bank or subsidiaries.
The second category comprises bank-
specific variables. The term LEVER is defined
as total equity/total assets (the proxy for the
leverage). The larger LEVER is, the smaller the
repayment risk will be. The term LIQUIDITY
(the proxy for the liquidity risk) is liquidity
assets/total liabilities, which represent the
liquidity available to a bank when it lacks
cash. The term MANAGE is the total earning
assets/total assets (the proxy for the manage-
ment efficiency); L/D is the loan/deposit ra-
tio (the proxy for loan policy); and BURDEN
is the (non-interest expenses– non-interest
income)/earning assets (which is often called
the burden ratio). The full definitions of the
variables and their meanings are provided in
Table 1.
The third category represents the macro-
variables, which are CR3 (the bank concentra-
tion ratio calculated from the three largest
95
banks), GDPper (the GDP per capita), EXCH
(the percentage change in the exchange rate),
RATE (the nominal deposit rate), and INFLA
(the inflation rate). See Table 1 for their defi-
nitions and the manner in which they are
constructed.
The focus of the model is on hi (i ¼ 1, 2, 3,
4), which respectively are the coefficients of the
four index variables, IBANK S ; IBANK I ; IBANK R ;
and IBANK N : The coefficients are explained as
follows. A negative hi implies that the tighter
restrictions have more severe adverse effects
on banks’ performance. The unique specifica-
tion of the model is that hi (i ¼ 1, 2, 3, 4) is
affected by G, which is the governance index.
This governance index is the composite index
obtained from La Porta et al. (1998). They ar-
gue that a strong system of legal enforcement
could step in and rescue investors abused by
management. The authors average four of
these measures as a proxy for the quality of
a government’s governance, namely, the effi-
ciency of the judicial system, rule of law, cor-
ruption, and the risk of expropriation. The
former two pertain to law enforcement proper,
while the latter two deal more generally with
the government’s stance toward business.6
Since each sub-index ranges from 1 to 10,
the summarized index also varies from 1 to
10, with a higher number meaning better
governance.
Our first interest is on whether the restric-
tion may deter a bank from earning higher
profits as a result of possible diversification.
Thus, the coefficients /i1 (i ¼ 1, 2, 3, 4) are
expected to be negative. Next, if the enhancing
restriction hypothesis is supported, then good
governance will strengthen the restriction ef-
fect, and the coefficients /i2 (i ¼ 1, 2, 3, 4)
should also be negative. Alternatively, if the
facility-supporting hypothesis is accepted, then
it might well be that good governance will mit-
igate this adverse effect, and the coefficient
/i2 (i ¼ 1, 2, 3, 4) is expected to be positive.
6. Each measure is accounted for as follows: (1) The
efficiency of the judicial system: Assessment of the ‘‘effi-
ciency and integrity of the legal environment as it affects
business.’’ (2) Rule of law: Assessment of the law and or-
der tradition in the country. (3) Corruption: Assessment of
the corruption in government, where lower scores indicate
that ‘‘high government officials are likely to demand spe-
cial payments’’ and ‘‘illegal payments are generally
expected throughout the lower levels of government.’’
(4) The risk of expropriation: Assessment of the risk of
‘‘outright confiscation’’ or ‘‘forced nationalization.’’
96 CONTEMPORARY ECONOMIC POLICY

TABLE 1
Mnemonics, Definitions, and Sources of Variables
Variable Definition Contents
Dependent variables:
ROA Return on assets Earning revenues/total assets
Explanatory variables:
The dummy variables of the degree of restriction:
IBANK S Restrictions on securities 1:unrestricted; 2:permitted; 3:restricted; 4:prohibited
IBANK I Restrictions on insurance 1:unrestricted; 2:permitted; 3:restricted; 4:prohibited
IBANK R Restrictions on real estate 1:unrestricted; 2:permitted; 3:restricted; 4:prohibited
IBANK N Restrictions on non-financial 1:unrestricted; 2:permitted; 3:restricted; 4:prohibited
firm ownership
The variable of governance:
G Governance index A composite index that is ranked from 1 to 10,
including the rule of law, corruption, the risk of
expropriation, and the efficiency of the judicial system
The variables of a bank’s performance:
LEVER Leverage Total equity/total assets
LIQUIDITY Liquidity risk Liquid assets/total liabilities
MANAGE Management efficiency Total earning assets/total assets
L/D Operation efficiency Total loans/total deposits
BURDEN Burden ratio (non-interest expenses – non-interest income)/earning
assets
The variables of the macro-environment:
CR3 Bank concentration (3 largest banks’ assets/all banks’ assets) * 100%
GDPper Per capita GDP GDP/population
EXCH D% of the nominal exchange rate ((exchange rate at time t
exchange rate at
time t
1)
1) * 100%
RATE Nominal deposit interest rate
INFLA Inflation rate ((CPI at time t – CPI at time t
1)
1) * 100%

The estimation of the model when the ROA
is the dependent variable is based on the OLS
and the random effects model for panel data.
The model choice, the random effect (but not
the fixed effect) model, is made so that the
authors can avoid bias in any estimation owing
to an excess of dummies on the right-hand side.
III. DATA SOURCE AND BASIC STATISTICS
A. Data Source
The 46 sample countries were selected fol-
lowing the studies of Barth et al. (2000) and
La Porta et al. (1998). The number of banks
in each country are reported in Table 2 and
amount to a total of 8,113 banks. The bank-
specific data, which are taken from BankScope,
are converted into U.S. dollars based on the ex-
change rate at the end of each year. The sample
period, 1995–1999, is the longest time span
available. The macro-variables are taken from
International Financial Statistics (IFS), pub-
lished by the International Monetary Fund.
B. Basic Statistics
Table 2 presents the four restriction indices,
the average ROA of all banks in a country, the
governance index, and the number of banks in
each country. The ROAs range from
3.59
(Indonesia) to 5.79 (Turkey), and the data
are unweighted averages. The highest gover-
nance index occurs in the Netherlands
(10.00), while the lowest is in the Philippines
(3.91). The number of banks adopted ranges
from 14 (New Zealand) to 1,715 (U.S.).
Comparing the basic statistical results
based on data from the U.S. and Germany
sheds light on the restrictive effects since the
former is well-known as a market-based sys-
tem and the latter as a bank-based system
(Demirguc-Kunt and Levine, 1999). Each
of the four restriction indices for the U.S.
has a value of 3, suggesting that a bank’s
 SHEN & CHANG: DO REGULATIONS AFFECT BANKING PERFORMANCE? 97

TABLE 2
Restriction Index, ROA, and Governance
Restrictions
Securities Insurance Real estate Non-financial ROA (%) Gov. index No. of banks

Argentina 3 2 2 3
0.13 5.82 175

Australia 1 2 3 2 1.25 9.45 109
Austria 1 2 1 1 0.73 9.44 126
Belgium 2 2 3 3 0.88 9.49 87
Brazil 2 2 3 3 2.66 6.50 253
Canada 2 2 2 3 0.89 9.73 67
Chile 3 2 3 3 1.04 6.77 66
Colombia 2 2 2 4
1.82 5.32 139
Denmark 1 2 2 2 1.78 9.92 142
Ecuador 2 4 4 NA 1.23 6.17 89
Egypt 2 2 3 3 1.76 5.21 42
Finland 1 3 2 1 1.13 9.92 28
France 2 2 2 2 0.45 8.92 483
Germany 1 3 2 1 0.84 9.27 1045
Greece 2 3 3 1 0.86 6.89 42
Hong Kong 1 2 2 3 1.50 8.76 177
India 2 4 4 2 1.00 6.13 82
Indonesia 2 4 4 4
3.59 3.95 81
Ireland 1 4 1 1 1.12 8.69 66
Israel 1 1 1 1 0.69 7.85 37
Italy 1 2 3 3 1.08 7.64 346
Japan 3 4 3 3
0.35 9.29 401
Jordan 2 4 3 2 0.88 6.14 21
South Korea 2 2 2 3
0.21 6.24 83
Malaysia 2 2 3 2 1.14 7.78 111
Mexico 3 4 3 3
0.20 5.85 98
Netherlands 1 2 2 1 1.19 10.00 85
New Zealand 1 1 1 2 1.26 9.92 14
Nigeria 1 2 2 2 4.14 4.59 56
Norway 2 2 2 2 1.18 9.97 71
Pakistan 2 4 3 1 1.28 4.16 29
Peru 2 2 2 2 1.13 4.87 62
Philippines 1 2 2 3 1.48 3.91 61
Portugal 1 2 3 2 0.77 7.62 66
Singapore 2 2 2 3 0.49 9.02 80
South Africa 2 2 1 1 2.89 6.56 71
Spain 1 2 3 1 1.13 7.74 371
Sri Lanka 2 2 2 2 1.87 4.99 23
Sweden 4 2 3 3 1.37 9.85 57
Switzerland 1 1 1 3 1.83 10.00 362
Thailand 2 2 2 3
2.01 5.53 64
Turkey 3 2 4 3 5.79 5.43 121
U.K. 1 2 1 1 1.42 9.35 360
U.S. 3 3 3 3 1.81 9.65 1715
Uruguay 3 2 3 4 1.20 5.77 21
Zimbabwe 2 4 4 4 4.31 5.55 28

Note: The ROA and the Gov. Index are calculated by the authors of this article. The period of the data is from
1995 to 1999.
Data source: Barth, Capiro, and Levine (2000); La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998).
98 CONTEMPORARY ECONOMIC POLICY

TABLE 3 the second highest ROA falls on those coun-

Basic Statistics—All Countries tries with the third restrictions (¼3). The
extent of the restrictions imposed on bank ac-
Degree of No. of sample
restriction ROA (%) Governance countries tivities does not appear to be directly related to
the ROA. But results show that the least re-
(A) Securities striction is together with the highest gover-
1 1.19 9.27 17 nance index, and they also show that the
2 1.00 6.17 21 tightest restriction is with the lowest gover-
3 1.04 5.85 7 nance index.
4 1.37 9.85 1
Panel B of Table 3 presents the basic statis-
(B) Insurance tics with regard to the restrictions in the insur-
1 1.26 9.92 3 ance industry. The results show that ROA
2 1.16 7.63 30 rises as the number of restrictions decrease.
3 1.00 9.46 4
Hence, fewer restrictions, vis-à-vis permission
4 1.00 6.13 9
to be involved in the insurance business, seem
(C) Real Estate to have a beneficial effect on banks’ perform-
1 1.26 9.35 7
ances. But in this panel, the relationship be-
2 1.13 8.76 17
tween restriction and governance is not clear.
3 1.13 7.62 17
Panel C of Table 3 reports the basic statis-
4 1.23 5.55 5
tics on the restrictions concerning real estate
(D) Non-Financial Firm Ownership
activity. Results show that the least restriction
1 1.13 8.69 11
is together with the highest governance index,
2 1.16 7.70 12
and they also show that the tightest restriction
3 1.06 7.21 18
4
0.31 5.44 4
is with the lowest governance index.
The last panel of Table 3 depicts the mixing
of bank and commerce. Fewer restrictions
engagement in other activities in the U.S. coincide with better governance indices as
is greatly restricted. The four indices for well as higher profits. Hence, both restrictions
Germany are 1, 3, 2, and 1, respectively, which and governance appear to affect overall bank
indicates that banks in Germany are allowed performance.
to engage in securities and mixed commerce.
The ROAs of the two countries are differ-
ent, at 1.81 (U.S.) and 0.84 (Germany), respec- IV. EMPIRICAL FINDINGS
tively, suggesting that U.S. banks perform
A. Impact on ROAs
better than those in Germany. A plausible rea-
son for this is attributed to the sample period Security Restrictions. Table 4 presents the es-
selected—the U.S. economy boomed during timated results when ROA is used as the de-
the late 1990s, coinciding with the sample size, pendent variable. The impact of restrictions
while German banks, however, suffered from on securities, insurance, and real estate as well
Russia’s 1998 currency crisis. Both countries as the mix of bank and commerce can be seen
do in fact display good governance, at 9.65 in the coefficients on IBANK S , IBANK I , IBANK R ,
and 9.27, respectively. The number of banks and IBANK N , respectively. The effects of gov-
in the two countries is also somewhat similar, ernance can be observed in the interactions be-
1,715 and 1,045, respectively. tween the restrictions and G.
Table 3 presents the basic statistics using In Table 4, the coefficient of IBANK S , /11 , is
the four restriction indices as a pivot. The found to be
0.0095, which is significantly
authors compute the median of the ROAs negative at the 1% level, implying that, as
when the restriction dummies fall into the a general rule, the imposition of restrictions
same range. In Panel A of Table 3, the results on banks’ security activities is unfavorable
show that tighter restrictions on security activ- in terms of bank profits. The coefficient of
ities do not necessarily reduce bank profits. the interactions between governance and
For example, except for the tightest restric- restrictions on securities (i.e., G * IBANK S ) is
tions (¼4), in which there is only one country, /12 ¼ 0.001, which is significantly positive at
while the highest ROA (which is 1.19) falls on the 1% level. This positive and significant
those countries with the least restrictions (¼1), /12 supports the authors’ facility-supporting
 SHEN & CHANG: DO REGULATIONS AFFECT BANKING PERFORMANCE? 99

TABLE 4
Benchmark Model—All Samples
Panel data
Explanatory variable OLS (random effects)
Constant
0.0085** (
4.21)
0.0051 (
1.89)
IBANK S
0.0095** (
4.94)
0.0113** (
3.78)
G * IBANK S 0.001** (4.33) 0.0012** (3.31)
IBANK I
0.023** (
9.55)
0.0275** (
7.47)
G * IBANK I 0.0028** (9.97) 0.0035** (8.13)
IBANK R 0.0323** (12.51) 0.0326** (8.30)
G * IBANK R
0.0036** (
11.15)
0.0037** (
7.60)
IBANK N
0.0183** (
12.35)
0.0148** (
6.57)
G * IBANK N 0.0019** (10.27) 0.0016** (5.60)
LEVER 0.1329** (61.37) 0.1635** (56.52)
LIQUIDITY
0.0016** (
8.87)
0.0008** (
4.72)
MANAGE 0.0038* (2.39)
0.0003 (
0.16)
L/D 7.08e
09 (0.31) 7.41e
10 (0.03)
BURDEN
0.0162** (
24.67)
0.0222** (
31.34)
GDPper
1.91e
07** (
3.57)
3.51e
07** (
4.97)
EXCH
0.0004** (
24.89)
0.0004** (
25.25)
RATE
0.0013** (19.13) 0.0012** (14.41)
INFLA
0.0005** (
9.25)
0.0005** (
8.83)
CR3 0.000046** (4.41) 0.000035** (3.38)
Variance of error term 0.00028
Variance of random effects 0.00071

Note: ** and * denote significance at the 1% and 5% levels, respectively. The t-values are in
parenthesis. Consistency of Heteroskedasticity-Robust Standard Errors are used to calculate t-values.

hypothesis that while regulatory restrictions on involvement in insurance are detrimental,

banks engaging in securities activities diminish
bank profits, good governance reduces their
harmful impact.
The authors’ specification also helps them
to calculate the turning-point of governance,
that is, at which point it reverses the negative
influences of those restrictions by turning
them into positive influences. This is done by
letting /11 þ /12 G ¼ 0; which yields G ¼ 9.5.
Restrictions on Insurance. The results of the
restrictions on insurance lead the authors to
arrive at a similar conclusion to that from
restrictions on securities. The coefficient on
IBANK I , /21 , is
0.023, which is significantly
negative at the 1% level. This strongly indi-
cates that the tighter restrictions on insurance
also have a negative impact on bank profits.
The coefficient on the interaction variable,
G * IBANK I , is 0.0028, again suggesting that
good governance mitigates the effects of the
negative impact. Hence, the facility-supporting
hypothesis is again supported. By letting
/21 þ /22 G ¼ 0, the turning-point is equal
to 8.21. That is, while restrictions on banks’
the negative impact is reduced when a country
has good governance.
Restrictions on Real Estate. Regulatory re-
strictions on banks dealing in real estate yield
conflicting findings to those obtained from the
restrictions on securities and insurance. In
contrast to the previous negative coefficients
on IBANK S and IBANK I , the estimated coeffi-
cient of IBANK R is positive (0.0323), and the
coefficient on G * IBANK R is
0.0036. Both
coefficients are significantly positive at the
1% level. The former implies that restrictions
on real estate increase bank profits, and the
latter implies that better governance lessens
this positive effect. A reverse facility-supporting
hypothesis is found. Hence, contrary to the
previous findings concerning unfavorable
restrictions, those over real restate seem to
be beneficial.
One possible explanation for this unex-
pected result is that the sample period,
1995–1999, happens to coincide with reces-
sions in the real estate markets of most coun-
tries. Restrictions on the right of banks to
100 CONTEMPORARY ECONOMIC POLICY
engage in real estate coincidentally protected
banks from conducting business in those
gloomy markets. For example, since land is
often used as collateral, the plummet in land
prices during the 1997–1998 Asian crisis and
the 1998–1999 Russian, Brazilian, and Turk-
ish crises hurt these countries’ bank profits.
Briefly stated, countries with tighter restric-
tions on real estate happened to insulate their
banks from investing in these falling markets,
thus shielding them from bad loans and, in ef-
fect, helping them make higher profits.
Restrictions on Commerce. Restrictions on
commerce result in similar findings to those
from restrictions on securities and insurance.
The coefficient of IBANK N is
0.0183, which
is significant at the 1% level, implying that
allowing banking and commerce to mix
decreases bank profits. The coefficient on
the interactions of G * IBANK N is 0.0019, which
is also significantly different from zero. Hence,
the facility-supporting hypothesis is again con-
firmed. Thus, good governance, in line with its
effects on bank profits as far as securities and
insurance go, reduces the negative impact
from mixing banking and commerce. By let-
ting /41 þ /42 G ¼ 0, the turning-point of
governance is 9.63.
The results do not change significantly
when the OLS method is extended to the ran-
dom effects model. The results in the second
column of Table 4 do not change qualitatively,
which clearly is indicative of the robustness of
the results.
B. Economic Effect of Restrictions and
Governance
Our study finds that when the governance
index exceeds 9.5, 8.21, and 9.63, respectively,
for the regulatory restrictions on securities, in-
surance, and mixed banking and commerce,
bank profits turn from negative to positive.
One appropriate example is taken from the
U.S. Because the governance index of the
U.S. is 9.65 and the three regulatory restric-
tions are 3, 3, and 3, respectively, the U.S.
matches the above scenario. Employing
restrictions on U.S. securities, for example,
without taking governance into account, the
marginal impact of restrictions on ROA is

0.095, but after taking this into account, the
impact becomes 0.00015. Thus, good gover-
nance turns the negative impact into a positive
one. It is worth noting that the article also
stresses the fact that good governance does
in fact minimize the detrimental effects from
restrictions. Thus, many countries could ben-
efit from good governance even though the
effects are not reversed.
V. ROBUSTNESS TESTING
A. Does Country Income Matter?
Table 5 reinvestigates the issue by classify-
ing all of the sample countries into the catego-
ries of low-, medium-, and high-income.
Because there are only five countries in the
low-income category (i.e., Nigeria, India,
Indonesia, Pakistan, and Zimbabwe), the
authors skip the discussion of their impacts.
With respect to high-income countries, re-
gardless of the method used, it is interesting
to note that the authors’ facility-supporting
hypothesis is still supported, i.e., tighter re-
strictions in securities shrink bank profits,
but good governance alleviates this negative
impact. Results are less obvious for the
medium-income countries, since G * IBANK S
is insignificantly different from zero.
The restriction on real estate leads to
the same results only when the OLS method
is employed, but not the random effects
model, regardless of country incomes. Restric-
tions on insurance and commerce become
insignificant regardless of the methods and
country income. Thus, results of restrictions
on security activities and real estate are robust
to different categories of country incomes.
The same argument, however, does not hold
true for the restrictions on insurance and
commerce.
B. Examining LLSV’s Argument
La Porta et al. (i.e., LLSV) (1998) argue
that securities in countries with higher investor
protection should be more valuable, since
investors in these countries can assure them-
selves of a return on their investment. Thus,
it is possible that the results that governance
improves performances are simply reflecting
LLSV’s argument, but not the hypothesis that
the authors are discussing.7 The authors thus
add the governance variable (i.e., G) as an
extra independent variable in addition to the
7. The authors thank one referee for pointing out
this view.
 SHEN & CHANG: DO REGULATIONS AFFECT BANKING PERFORMANCE? 101

TABLE 5
Robust Testing (I)—Different Income Countries
Medium-income High-income
Panel data Panel data
Explanatory variable OLS (random effects) OLS (random effects)
Constant
0.0351** (
3.84)
0.0147 (
1.07)
0.012** (
7.25)
0.0087** (
4.15)
IBANK S
0.0513** (
4.07)
0.047* (
2.17)
0.07** (
12.35)
0.0712** (
7.6)
G * IBANK S 0.0079** (3.65) 0.0069 (1.88) 0.0075** (12.21) 0.0077** (7.58)
IBANK I 0.0089 (0.38)
0.0196 (
0.53) 0.0112 (1.61) 0.0174 (1.54)
G * IBANK I
0.0021 (
0.53) 0.0027 (0.44)
0.0012 (
1.59)
0.002 (
1.63)
IBANK R 0.047** (2.81) 0.0513 (1.95) 0.014** (3.03) 0.0071 (0.94)
G * IBANK R
0.0053* (
1.97)
0.0064 (
1.5)
0.0013* (
2.51)
0.0004 (
0.5)
IBANK N
0.01 (
0.87) 0.0006 (0.03)
0.0008 (
0.39) 0.0012 (0.37)
G * IBANK N
0.0007 (
0.33)
0.0022 (
0.67)
0.0001 (
0.49)
0.0004 (
1.06)
LEVER 0.102** (15.8) 0.122** (13.1) 0.0902** (52.31) 0.0921** (40.88)
LIQUIDITY
0.0004 (
1.09)
0.0003 (
0.8)
0.0013** (
7.17) 0.00007 (0.5)
MANAGE 0.0341** (6.79) 0.0213** (3.1) 0.0073** (5.93) 0.0082** (6.24)
L/D 2.23e
06 (1.07) 1.82e
06 (0.59) 3.56e
08* (2.49) 1.99e
09 (0.14)
BURDEN
0.009** (
8.39)
0.0165** (
12.82)
0.085** (
48.08)
0.073** (
36.67)
GDPper 1.93e
06**(3.75) 1.44e
06 (1.83) 1.83e
07** (4.08) 1.03e
07* (2.01)
EXCH
0.00008 (
1.37)
0.0001 (
1.79) 0.0001** (5.41) 0.00008** (5.14)
RATE 0.0015** (8.09) 0.0013** (5.56) 0.0011** (8.55) 0.0002 (1.14)
INFLA
0.0007** (
5.96)
0.0005** (
3.73) 0.0003* (2.15) 0.0006** (4.81)
CR3 1.88e
06 (0.02)
0.0001 (
1.33) 0.00003** (3.89) 0.00003** (5.98)
Variance of error term 0.0007 0.00016
Variance of random effects 0.00182 0.00022

Note: ** and * denote significance at the 1% and 5% levels, respectively. The t-values are in parenthesis. Consistency of
Heteroskedasticity-Robust Standard Errors are used to calculate t-values.

interaction between the governance index and C. Outlier Effects

the restriction index. If G is found to have
Banks in some countries display extremely
a significant impact in the presence of the in-
high positive ROAs (for example, Nigeria,
teraction variable, then the authors’ finding
Turkey, and Zimbabwe, where some banks’
may support more of LLSV’s argument and
ROAs exceed 4%), which are unusual in the-
less of the authors’ hypothesis; otherwise, it
ory. The high ROA may be due to the extraor-
is not. As shown in Table 6, the coefficient
dinarily good performance, low leverage, or
of this extra variable (G), however, is not
simply that the accounting systems in these
significantly different from zero, but the inter-
countries are specific. Because the authors
action terms remain significant. Hence, the
cannot detect which reasons are most likely,
facility-supporting hypothesis still gains sup-
they use the following two methods to inves-
port even when G is added in, but LLSV’s
tigate the robustness of the results. First, these
argument is refuted.8
high ROA banks are dealt with as outliers and
are removed from the data, and 205 observa-
tions are excluded. The estimated results are
8. The authors further separate the banks into govern-
ment-owned banks versus publicly held banks to reinves- reported in Table 7. The authors find that
tigate LLSV’s argument. The government banks are results do not change qualitatively after the
defined as ones in which outstanding shares held by the outliers are removed.
government exceed 20%. There are 163 government-
owned banks from 30 countries. Using government-
Because the banking industry is a high-
owned banks, the hypothesis is still supported and LLSV’s leverage industry, the authors next remove
argument is refuted, because the coefficient of the gover- banks in each country with a lower leverage
nance variable is significantly negative and restrictions on (using equity/asset ratio ¼ 30% as a cutoff)
interaction variables do not change too much. On the
other hand, using the publicly held banks, the coefficient from the data to examine the robustness,
of G remains insignificant. and 418 observations are excluded. A bank
102 CONTEMPORARY ECONOMIC POLICY

TABLE 6
Robust Testing (II)—LLSV’s Argument
Panel data
Explanatory variable OLS (random effects)
Constant
5.90e
03 (
0.91)
0.017 (
1.69)
IBANK S
9.74e
03** (
4.86)
0.010** (
3.26)
G * IBANK S 1.04e
03** (4.32) 1.10e
03** (2.95)
IBANK I
0.023** (
9.56)
0.027** (
7.32)
G * IBANK I 2.84e
03** (9.97) 3.42e
03** (7.88)
IBANK R 0.032** (12.22) 0.033** (8.40)
G * IBANK R
3.55e
03** (
10.98)
3.74e
03** (
7.68)
IBANK N
0.019** (
10.57)
0.013** (
4.66)
G * IBANK N 1.99e
03** (9.01) 1.34e
03** (3.94)
LEVER 0.133** (61.33) 0.164** (56.53)
LIQUIDITY
1.62e
03** (
8.88)
8.42e
04** (
4.73)
MANAGE 3.82e
03* (2.40)
3.73e
04 (
0.19)
L/D 7.21e
09 (0.31) 4.38e
10 (0.02)
BURDEN
0.016** (
24.67)
0.022** (
31.32)
GDPper
1.83e
07** (
3.21)
3.78e
07** (
5.11)
EXCH
3.90e
04** (
24.68)
3.76e
04** (
25.27)
RATE 1.33e
03** (19.04) 1.22e
03** (14.15)
INFLA
5.35e
04** (
9.26)
5.40e
04** (
8.78)
CR3 4.57e
05** (4.40) 3.54e
05** (3.44)
G
3.21e
04 (
0.43) 1.41e
03 (1.22)
Variance of error term 2.81e
04
Variance of random effects 7.08e
04

Note: ** and * denote significance at the 1% and 5% levels, respectively. The t-values are in
parenthesis. Consistency of Heteroskedasticity-Robust Standard Errors are used to calculate t-values.

TABLE 7
Robust Testing (III)—Outliers (ROA Exceed 4%) Excluded
Panel data
Explanatory variable OLS (random effects)
Constant
1.06e
03 (
0.51) 2.88e
03 (1.04)
IBANK S
0.013** (
6.78)
0.017** (
5.54)
G * IBANK S 1.42e
03** (6.01) 1.78e
03** (4.87)
IBANK R
0.013** (
4.85)
0.012** (
2.99)
G * IBANK I 1.62e
03** (5.29) 1.65e
03** (3.50)
IBANK R 0.019** (6.69) 0.012** (2.74)
G * IBANK R
2.04e
03** (
5.92)
1.31e
03* (
2.46)
IBANK N
0.014** (
8.86)
7.59e
03** (
3.27)
G * IBANK N 1.42e
03** (7.42) 7.75e
04** (2.70)
LEVER 0.130** (60.60) 0.160** (55.70)
LIQUIDITY
1.55e
03** (
8.62)
8.29e
04** (
4.67)
MANAGE 9.89e
04 (0.62)
2.22e
03 (
1.15)
L/D 5.18e
09 (0.23)
3.27e
10 (
0.01)
BURDEN
0.016** (
24.01)
0.021** (
30.57)
GDPper
2.87e
07** (
5.29)
4.43e
07** (
6.27)
EXCH
3.87e
04** (
24.66)
3.75e
04** (
25.14)
RATE 1.18e
03** (16.77) 9.94e
04** (11.00)
INFLA
7.41e
04** (
12.03)
6.23e
04** (
9.84)
CR3 4.73e
05** (4.60) 3.82e
05** (3.74)
Variance of error term 2.64e
04
Variance of random effects 6.99e
04

Note: ** and * denote significance at the 1% and 5% levels, respectively. The t-values are in
parenthesis. Consistency of Heteroskedasticity-Robust Standard Errors are used to calculate t-values.
 SHEN & CHANG: DO REGULATIONS AFFECT BANKING PERFORMANCE? 103

TABLE 8
Robust Testing (IV)—Outliers (Leverage Exceeds 30%) Excluded
Panel data
Explanatory variable OLS (random effects)
Constant
3.46e
03* (
2.20) 4.39e
04 (0.22)
IBANK S
2.36e
03 (
1.59) 8.15e
04 (0.36)
G * IBANK S 2.73e
04 (1.52)
3.10e
05 (
0.11)
IBANK I
0.016** (
8.42)
0.020** (
7.50)
G * IBANK I 1.99e
03** (9.23) 2.65e
03** (8.37)
IBANK R 0.026** (12.90) 0.027** (9.39)
G * IBANK R
2.69e
03** (
11.01)
2.89e
03** (
8.06)
IBANK N
0.019** (
16.26)
0.017** (
9.94)
G * IBANK N 1.87e
03** (12.81) 1.64e
03** (7.78)
LEVER 0.185** (68.50) 0.222** (68.77)
LIQUIDITY
4.90e
03** (
9.90)
4.99e
03** (
10.43)
MANAGE
4.50e
03** (
3.61)
9.31e
03** (
6.63)
L/D 8.76e
08** (4.83) 3.99e
08* (2.23)
BURDEN
0.174** (
77.02)
0.265** (
145.37)
GDPper
9.90e
08* (
2.44)
2.03e
07** (
4.03)
EXCH
3.42e
04** (
28.14)
3.04e
04** (
29.22)
RATE 1.19e
03** (22.24) 9.19e
04** (14.86)
INFLA
3.07e
04** (
6.79)
9.45e
05* (
2.16)
CR3 2.53e
05** (3.26) 2.13e
05** (3.07)
Variance of error term 1.82e
04
Variance of random effects 3.61e
04

Note: ** and * denote significance at the 1% and 5% levels, respectively. The t-values are in
parenthesis. Consistency of Heteroskedasticity-Robust Standard Errors are used to calculate t-values.

with a low leverage implies that it may not be
a pure bank, even though its name contains
the word ‘‘bank.’’ The estimated results are
reported in Table 8. The authors find that
results do not change qualitatively.
D. Does U.S. Data Dominate the Results?
The authors mentioned above that restric-
tions on banks’ businesses are dynamic pro-
cesses and hence may not be completely
consistent with the current situation. For ex-
ample, banks in the U.S. have been allowed
to engage in limited security business transac-
tions since 1987. It may thus cast some doubts
about the validity of the restriction index re-
garding the U.S. case. The authors thus
remove the U.S. banks, amounting to 1,715,
from the sample and investigate the robustness
of results. The estimated results are reported in
Table 9. As can be seen, results do not change,
and the conclusion holds true.
VI. DISCUSSION AND CONCLUSIONS
This article studies the effects on bank prof-
its and the risks involved from restrictions on
the right of commercial banks to engage in
three financial activities and one non-financial
activity. The former comprises securities, in-
surance, and real estate, while the latter con-
tains a mix of banking and commerce. The
model further specifies impact as the func-
tion of government governance (i.e., the rule
of law), which allows the authors to in-
vestigate two conflicting hypotheses, i.e., the
restriction-enhancing hypothesis and the
facility-supporting hypothesis. The former ef-
fect suggests that good governance enhances
the effect of restrictions, and the latter sug-
gests the opposite effect.
Our study finds that restrictions on com-
mercial banks’ engagement in securities and
insurance, as well as those on the mixing of
banking and commerce, reduce bank profits.
One exception is the restrictions on real es-
tate, which have a positive effect on bank
profits. The authors attribute these counterin-
tuitive results to the plummeting land prices
in most countries during a period that coin-
cided with the sample period. Hence, the
restrictions on real estate activities happened
to prevent banks from investing in a slumping
104 CONTEMPORARY ECONOMIC POLICY

TABLE 9
Robust Testing (V)—Without U.S. Data
Panel data
Explanatory variable OLS (random effects)
Constant
4.80e
03 (
1.82) 3.89e
03 (1.14)
IBANK S
6.30e
03** (
2.82)
8.53e
03* (
2.53)
G * IBANK S 4.87e
04** (1.76) 6.65e
04 (1.58)
IBANK I
0.025** (
9.02)
0.027** (
6.56)
G * IBANK I 3.06e
03** (9.41) 3.48e
03** (7.25)
IBANK R 0.035** (11.84) 0.036** (8.18)
G * IBANK R
3.96e
03** (
10.77)
4.32e
03** (
7.94)
IBANK N
0.021** (
11.36)
0.022** (
8.11)
G * IBANK N 2.31e
03** (9.58) 2.66e
03** (7.55)
LEVER 0.127** (50.73) 0.156** (47.63)
LIQUIDITY
1.62e
03** (
7.87)
9.71e
04** (
4.71)
MANAGE 5.20e
03** (2.86) 1.38e
03 (0.63)
L/D 9.40e
09 (0.37) 3.23e
09 (0.11)
BURDEN
0.616** (
21.32)
0.022** (
27.83)
GDPper
2.45e
07** (
3.86)
5.27e
07** (
6.20)
EXCH
3.83e
04** (
21.67)
3.71e
04** (
22.17)
RATE 1.25e
03** (15.60) 1.21e
03** (12.41)
INFLA
5.01e
04** (
7.63)
5.09e
04** (
7.32)
CR3 6.68e
06 (0.26)
1.28e
04** (
3.82)
Variance of error term 3.28e
04
Variance of random effects 9.09e
04

Note: ** and * denote significance at the 1% and 5% levels, respectively. The t-values are
in parenthesis. Consistency of Heteroskedasticity-Robust Standard Errors are used to calculate
t-values.

real estate market during the period of this
study.
Good governance is found overwhelmingly
to mitigate the above-mentioned restriction
impacts. That is, the facility-supporting hy-
pothesis is supported. In fact, when the gover-
nance index is high enough, the previous
negative effects even become positive.
Restrictions on banks’ engagement in the
insurance business seem to yield greater losses
than other restrictions, since the size of the
negative coefficient is the largest. Such heavy
losses incurred from restricting banks from en-
gaging in insurance are consistent with recent
studies by Lown, Osler, Strahan, and Sufi
(2000) and Estrella (2000), who report that
any merger between banks and insurance
companies may be more profitable than any
merger between banks and securities and real
estate businesses. In their studies, restrictions
on securities yield the smallest negative coeffi-
cient, meaning that banks suffer less when
national regulatory authorities do not allow
banks to engage in securities. In Europe,
a new term of ‘‘bancassurance,’’ referring to
banks selling insurance, has become quite
popular. Allowing banks to engage in in-
surance reveals the potential synergy to
bring in profits. The results indirectly confirm
this.
Several robust testings were also con-
ducted. First, the results held true for high-
income countries when banks were allowed
to engage in securities and real estate. The
results, however, became less obvious for
medium-income countries. The authors also
added a governance variable to investigate
LLSV’s argument that good governance can
enhance firm value. In the presence of the in-
teraction variable of governance and restric-
tion variables, the additional governance
variable was not significant. The outliers
may also distort the results, and hence the
authors removed those banks with extremely
high ROA or low leverage in order to reinves-
tigate the robustness. Again, the results did
not change. The U.S. banks were removed,
and the results did not change.
 SHEN & CHANG: DO REGULATIONS AFFECT BANKING PERFORMANCE?
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