Emerging Markets Finance and Trade

ISSN: 1540-496X (Print) 1558-0938 (Online) Journal homepage: http://www.tandfonline.com/loi/mree20

What Forms and Reforms Banking Regulations? A

Cross-National Study

Hyunchul Kim, Minsoo Park & Hyunduk Suh

To cite this article: Hyunchul Kim, Minsoo Park & Hyunduk Suh (2014) What Forms and
Reforms Banking Regulations? A Cross-National Study, Emerging Markets Finance and Trade,
50:6, 72-89, DOI: 10.1080/1540496X.2014.1013873

To link to this article: http://dx.doi.org/10.1080/1540496X.2014.1013873

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 What Forms and Reforms Banking Regulations?
A Cross-National Study
Hyunchul Kim, Minsoo Park, and Hyunduk Suh

ABSTRACT: We examine the determinants of regulatory frameworks in the banking sector

using an extensive data set of regulations of more than 180 countries. In contrast with
previous studies, we analyze multiple aspects of regulations independently in terms of their
objects and functions, controlling for political and economic conditions that might affect
regulatory structures. We find that each dimension of regulations is determined by different
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factors, and the incentives for the formulation of regulations differ between emerging and
developed economies. Emerging economies regulate banking activities, entry, and foreign
bank operations more tightly than do developed economies; however, emerging economies
impose fewer restrictions on private monitoring requirements.
KEY WORDS: banking regulation and supervision, determinants of bank regulation, financial
crisis and stability, financial reform.

Financial regulation is imposed in the interest of making financial markets resilient to

domestic and external shocks and preventing the reoccurrence of financial crises. Although
most countries’ regulatory systems share this objective, the way financial regulation is
developed and evolves varies substantially across economies. Our key research question
examines how different economic and political conditions shape a country’s financial
regulatory framework. We focus on the determinants of banking regulation and super-
vision in emerging markets and developing economies, with an emphasis on political
regimes, financial stability, and various indicators of macro conditions and financial
market development. We use survey-based information on bank regulation for a large
sample of developed and developing economies. This data set contains information on
a sufficiently wide range of regulatory frameworks of the banking sector to enable us to
identify independently the determinants of multiple dimensions of regulatory structures.
We divide the survey questions, according to object and function, into five groups: bank-
ing activities, capital requirement, private monitoring, market structure, and supervisory
power. We use five separate measures because a single index captures only the composite
effects of its determinants, ignoring the idiosyncrasy of the individual dimensions of
regulations.
We find that the effects of the potential determinants differ in each dimension of
banking regulations; incentives for emerging markets to formulate regulations also differ
from those of developed economies. Overall, low- to middle-income countries rely more
on ex ante regulations such as bank activity and market entry; high-income countries

Hyunchul Kim (hchkim@skku.edu), first author, is an assistant professor of economics in the Depart-
ment of Economics, Sungkyunkwan University, Seoul, South Korea. Minsoo Park (minsoopark@
skku.edu), corresponding author, is an associate professor of economics in the Department of
Economics, Sungkyunkwan University, Seoul, South Korea. Hyunduk Suh (hyunsun09@gmail.
com) is an assistant professor of economics in the Department of Economics, Inha University, South
Korea. The authors thank Won Sung for his superb research assistance. This paper was supported
by Faculty Research Fund, Sungkyunkwan University, 2013.

Emerging Markets Finance & Trade / November–December 2014, Vol. 50, No. 6, pp. 72–89.
© 2014 Taylor & Francis Group, LLC. All rights reserved. Permissions: www.copyright.com
ISSN 1540–496X (print) /ISSN 1558–0938 (online)
DOI: 10.1080/1540496X.2014.1013873
 November–December 2014 73

with more-developed financial markets impose stricter ex post regulation such as capital
regulation and private monitoring requirements. This is because high-income countries
are in a better position to implement ex post regulation due to their greater experience
and more advanced technology in assessing and quantifying risks in banking activity.
Furthermore, we find that, following the 2008 global financial crisis, the world econo-
mies strengthened regulations on capital requirements and market entry but weakened
regulations governing supervisory power and discretion.
While the effects of financial liberalization on long-term economic development and
financial stability have been studied widely, only recently has attention turned toward
the factors determining financial regulation.1 Abiad and Mody (2005), using an index
of financial liberalization, identify three sources of financial reforms: external shocks,
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learning, and government ideology and structure. Kim and Kenny (2007) find that trad-
ing with more-developed countries creates an incentive among developing countries to
liberalize equity markets at an earlier date.
It is well documented in the literature that incentives for financial reform may differ
between developed and emerging (or developing) economies. Vives (2006) argues that
the regulatory system in emerging economies, which suffer from asymmetric information
problems resulting from political instability, tends to be protective of banks’ traditional
intermediary services (deposits and loans) in the face of systemic risk. Prasad (2010)
documents that economies with underdeveloped financial markets prefer rules-based regu-
lations, whereas those with advanced financial markets adopt principle-based regulation
systems. Such arguments in the literature emphasize the distinguishing characteristics of
emerging economies’ financial markets as reasons for further analysis of the determinants
of banking regulation in these economies.
Our study contributes to the existing literature in three ways. First, anticipating that
regulatory frameworks may vary with idiosyncratic circumstances across economies,
we analyze independently the determinants of each dimension of regulatory structure.
Second, we examine an extensive set of determinants likely to affect regulatory frame-
works. Third, we analyze the effect of the 2008 financial crisis on different aspects of
banking regulation.

Theories of Banking Regulation

We conduct a survey of theories within each category of banking regulation and assess
how underlying economic circumstances affect banking regulations in theory.

Banking Activities

The 2008 financial crisis aroused skepticism about universal banking that combines
traditional intermediary services with investment banking services such as underwriting
equity and debt issues.2 Berger et al. (2000) cite potential gains in efficiency from exploit-
ing scale and scope economies in a financial market as the main benefit of providing
investment banking services. However, Morrison (2012) finds that permitting universal
banking aggravates systemic risk due to conflicts of interest between parent banks and
their security dealer affiliates. Rajan (1995) argues that an understanding of the economic
environments of individual countries is crucial to any attempt to predict the overall effects
of universal banking on financial development and stability.
 74 Emerging Markets Finance & Trade

Capital Requirements
Diamond and Rajan (2000) document that the capital adequacy requirement, although it
plays a role in mitigating financial distress arising from the fragility of the demand deposit
structure at its root, is costly because it limits the size of liquidity creation. The capital
adequacy requirement has the further goal of alleviating moral hazard problems in banks’
monitoring function. The capacity to monitor borrowers is essential for the enlargement
of funds and investments, which is required for an economy’s development. However,
because monitoring cost is private information, banks are inherently confronted with moral
hazard problems in their monitoring activity (Holmstrom and Tirole 1997). Requiring
banks to put their own stakes in investment projects thus creates an incentive for credible
monitoring. The Basel Capital Accords reflect not only the risk of an individual bank but
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also financial systemic risk. Such capital requirements can be particularly challenging in
developing economies in which banks are likely to finance riskier projects and lack the
ability to evaluate attendant risks.

Private Monitoring
Beck et al. (2006) divide existing views on the role of public- and private-sector bank
supervision into three categories. The “supervisory power view,” which holds that tight
regulation can improve corporate governance in the absence of private investors’ incentive
and ability to monitor banks, is countered by the “regulatory capture view,” which posits
that excessive authority of regulators positioned to extract private benefits can be detri-
mental. The “private empowerment view” maintains that bank supervision should focus
on enhancing private investors’ ability to monitor banking activity. Given that economies
with underdeveloped financial markets and weak institutional structures are less capable
of satisfying an adequate standard of private monitoring, the regulation involving private
monitoring is expected to be less stringent in emerging and developing economies.

Market Structure and Entry Restriction

Market structure can be viewed from both efficiency and stability perspectives. In the
efficiency point of view, Pagano (1993) argues that restrictive regulations that inhibit
competition widen banks’ margins, and the resulting inefficiency retards economic growth.
Petersen and Rajan (1995) document that market competition restricts banks’ ability to
finance small firms by intertemporally sharing surplus with them. Shaffer (1998) further
finds that, when capacities of credit screening differ across banks, the quality of accepted
loan applications declines as the number of banks increases (adverse selection). In the
stability point of view, Keeley (1990) argues that restrictions on entry and competition
minimize incentives for excessive risk taking because less competition is more likely to
secure banks’ charter values, thus ensuring financial stability. Boyd and De Nicoló (2005)
point out the importance of heterogeneity in market power in studying the relationship
between competition and stability in the banking sector, and Pino and Araya (2013)
empirically verify this using bank-level data for Chile.

Supervisory Power
According to the supervisory power view, supervisory authorities’ greater reliance on
public resources to regulate and supervise the financial sector in emerging and developing
 November–December 2014 75

economies may be a consequence of the private sector monitoring function being founded
on weak institutional structures. Regarding the independence of regulatory authority from
governments, Gadinis (2013) and Quintyn and Taylor (2002) argue that lack of indepen-
dence can adversely influence financial stability, but there exists a counterargument that
more-centralized presidential control can enhance accountability among regulators who
face difficult choices (Gadinis 2013).

Evolutionary Paths of Financial Regulation

The history of financial regulation reform shows that individual dimensions of financial
regulation often evolve along different paths in terms of stringency and sophistication.
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This is because distinct components of regulations not only have specific implications for
financial stability and development, but also require different levels of financial market
development and economic growth. The evolution of Korean financial sector in the first
decade of the 2000s is a good example of divergence in financial regulation reforms.3

Data

Index of Banking Regulation

We use data on bank regulation and supervision collected by Barth et al. (2013) from
the World Bank surveys covering more than 180 countries. The survey was performed
four times: in 1999, 2002, 2006, and 2011. Responses to original survey questions that
capture a similar aspect of regulatory practices are aggregated into a single index. We
mostly follow Barth et al. (2013) but slightly reorganize the indexes in order to define the
measures of the five regulatory dimensions of interest. The indexes are based on ordinal
or continuous values from the survey questions.
The indexes of regulation governing bank activity, summarized in Table 1 along
with other indexes, build on six variables that measure the extent to which banks are
permitted to engage in nontraditional intermediary services and to own, or be owned by,
nonbank financial or nonfinancial firms. Capital regulation is measured by the indexes
according to the following variables: overall capital stringency, initial capital stringency,
loan classification and provisioning stringency, and asset diversification index. Bank
loans classified as bad quality (unlikely to be paid) and thus requiring provisioning
deteriorate capital adequacy. The stringency of loan classification and provisioning is
reported in pure numbers; the other variables are in ordinal numbers.4 Higher values of
the indexes represent tighter restrictions on bank activities and more-stringent capital
requirements.
The indexes of private monitoring measure the extent to which related regulations
induce or require private incentives or capacity for monitoring banks. The indexes are
based on four variables built on numerous questions about external rating and account-
ing standards and required level of transparency of financial statements. These four
variables are strength of external audit, accounting practices, external ratings and credi-
tor monitoring, and financial statement transparency. Higher indexes indicate better or
more-private monitoring prescribed by regulations. Regulation of market structure and
entry is measured by the indexes of entry requirements and limitations on foreign bank
entry and ownership. Higher values of the indexes mean more restrictions on entry and
foreign bank operations. The indexes of supervisory power build on questions about the
 76 Emerging Markets Finance & Trade

Table 1. Indexes of bank regulations

Range of
Index values Definition and source

Bank activities
Activity restriction 3–12 The extent to which banks are prohibited from engaging in
nontraditional services such securities, insurance, and
real estate
Ownership restriction 3–12 The extent to which banks are prohibited from owning or
being owned by nonfinancial firms
Combined index 6–24 The sum of the indexes of activity and ownership
restrictions
Capital requirements
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Capital stringency 0–10 The stringency of requirements on overall and initial capital
Combined index 0–15 The sum of the capital stringency index and the three
other indexes that measure the stringency of loan
classification and provisioning
Private monitoring
External ratings and 0–5 The evaluations by external rating agencies and incentives
creditor monitoring for creditors of the bank to monitor bank performance
Combined index 0–12 The sum of the index of external ratings and creditor
monitoring and three other indexes of external audit
strength, accounting practices, and financial statement
transparency
Market entry
Requirements for 0–8 Whether various types of legal submissions are required to
market entry obtain a banking license
Restrictions on 0–4 The stringency of restrictions on foreign banks owning
foreign banks domestic banks and their entry into a country’s banking
industry
Supervisory power
Power 0–14 Whether the supervisory authorities have the authority to
take specific actions to prevent and correct problems
Independence 0–3 The degree to which the supervisory authority is
independent of political influence and consideration and
legally protected for their actions
Discretion 0–4 Whether the supervisory authorities may have discretion
when confronted with violations of laws and regulations
or other imprudent behavior

power, independence, and discretion of supervisory authorities. The independence index

measures supervisory authorities’ independence from political influence and the market.
Higher indexes indicate greater supervisory power, independence, and discretion.

Measures of Determinants
We consider four categories of potential determinants of banking regulation and super-
vision: financial stability, financial development, institutional variables, and various
macroeconomic indicators. The definitions of the variables, along with the data sources,
are presented in Table 2; summary statistics are presented in Table 3.
We use the financial stability data collected by Laeven and Valencia (2012). The data
set contains the most up-to-date information on 147 banking crises that occurred between
 November–December 2014 77

Table 2. Variables, definitions, and sources

Variable Definition and source

Financial stability
Financial Crisis (years) Years of financial crises since 1970
Financial development
Credit to GDP Private credit by deposit money banks and other financial institutions
to GDP; IMF’s International Financial Statistics
Overhead costs Overhead costs of a bank as a share of the value of all assets held;
Bankscope
ROA Return on assets; Bankscope
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ROE Return on equity; Bankscope

Operating costs Operating expenses of a bank as a share of sum of net-interest revenue
and other operating income; Bankscope
Credit to government Ratio between credit by domestic money banks to the government and
state-owned enterprises and GDP; IMF’s International Financial
Statistics
Credit to deposit The financial resources provided to the private sector by domestic
money banks as a share of total deposits; IMF’s International
Financial Statistics
Political institutions
Executive election Executive election dummy (equals 1 if there was an executive election
in the year); World Bank’s Database of Political Institutions (DPI)
Government vote Total vote share of all government parties; World Bank’s Database of
Political Institutions (DPI)
Opposition vote Total vote share of all opposition parties; World Bank’s Database of
Political Institutions (DPI)
Right turn Right-turn dummy (equals 1 if the party orientation with respect
to economic policy turns to “Right” from “Center” or “Left” or
turns to “Center” from “Left”); World Bank’s Database of Political
Institutions (DPI)
Left turn Left-turn dummy (equals 1 if the party orientation with respect to
economic policy turns to “Left” from “Center” or “Right” or turns
to “Center” from “Right”); World Bank’s Database of Political
Institutions (DPI)
Commonwealth Dummy for the member of the Commonwealth of Nations
Macro indicators
Inflation Inflation rate—annual percentage change of average consumer price;
IMF’s World Economic Outlook (WEO)
Government balance Government net lending and borrowing to GDP—net lending (+)/
to GDP borrowing (–) is calculated as revenue minus total expenditure; IMF’s
World Economic Outlook (WEO)
Middle-Low income Middle- or low-income country dummy; World Bank
Other variables
Region Region dummy (countries belong to one of the following regions:
[1] East Asia and Pacific; [2] non-EU Europe and Central Asia;
[3] EU members; [4] Latin America and the Caribbean; [5] Middle
East and North Africa; [6] North America; [7] South Asia; [8] Sub-
Saharan Africa); World Bank
Time dummy Time dummy
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78

Table 3. Summary statistics of variables

Standard
Variable Unit Mean deviation Minimum Maximum Median

Financial stability
Financial Crisis (years) Number of years 1.79 2.44 0 10 0
Financial development
Credit to GDP Percent 46.40 47.38 0.77 380.72 29.26
Overhead costs Percent 3.99 2.81 0.05 19.62 3.54
ROA Percent 1.34 2.17 –24.29 12.44 1.20
ROE Percent 14.22 23.74 –179.15 304.90 13.30
Operating costs Percent 59.84 25.92 3.82 527.78 58.66
Credit to government Percent 10.08 11.23 0.003 71.46 5.96
Credit to deposit Percent 93.37 64.30 9.46 729.42 81.78
Political institutions
Executive election Count 0.39 0.52 0 2 0
Government vote Percent 34.59 28.17 0 100 40.87
Opposition vote Percent 22.82 20.88 0 75.10 22.76
Right turn Count 0.02 0.12 0 1 0
Left turn Count 0.01 0.10 0 1 0
Commonwealth Count 0.24 0.43 0 1 0
Macro indicators
Inflation Percent 10.96 50.11 –35.82 1,180.80 4.49
Government balance to GDP Percent –1.60 5.70 –28.33 53.87 –2.23
Middle-Low income Count 0.72 0.45 0 1 1
 November–December 2014 79

1970 and 2011 including details of their effects and policy responses. Because the effect
of crises on financial regulations tends to last for a long time, we calculate the number of
years for which each country has experienced banking crises since 1970. For the variables
of financial developments, we use the Global Financial Development Database collected
by the World Bank, which covers 203 countries between 1960 and 2011. The data include
information on size, efficiency, and stability of financial institutions and markets. Among
the numerous variables, we use the ratio of private credit to gross domestic product (GDP)
as a proxy for the size of financial markets, cost variables, return on assets (ROA), and
return on equity (ROE), and we use the ratio of bank credit to the government to GDP
as a measure of the efficiency of financial markets.5 We also use the ratio of bank credit
to deposits, which indirectly measures sources other than deposits (e.g., issuing bonds)
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used to finance lending, to measure so-called noncore liabilities. Because an increase in

noncore liabilities indicates credit growth with less-stable sources of funding, associated
with banks’ risk-taking behavior, we treat this variable as a proxy for the stability of the
banking sector.6
Political and institutional variables—the indicator of executive election, total share of
government and opposition parties, and party orientation—are obtained from the Database
of Political Institutions (DPI), collected and updated by the World Bank.7 Because bank
regulations are also affected by macroeconomic indicators such as economic growth and
stability, we use inflation rate and the size of the government financial balance (net lend-
ing and borrowing) as a proxy for economic stability. The sample countries are grouped
into low- to middle-income and high-income economies. Approximately 90 percent of
the low- to middle-income countries are classified in the International Monetary Fund
(IMF) World Economic Outlook Database as emerging and developing economies. We
also include dummies for eight regions.

Estimation Model and Results

Estimation Model
To identify the determinants of regulatory status in the banking sector, we estimate the
following regression equation:
Regit = α + β1 Inc it −1 + β2 InStabit −1 + Others it −1Γ + ε it , (1)
where Regit represents the banking regulations of country i at period t; Inc is income level;
InStab is financial instability; and Others represents other determinants such as financial
development, political institutions, and macroeconomic status. Potential determinants
may affect regulatory frameworks with some time lag rather than instantaneously. To
reflect the time-consuming process of building and reforming any kind of institution,
explanatory variables are constructed as an average over the years after the last banking
regulation survey, excluding the year in question. For example, the explanatory variables
for banking regulations in 2006 are defined as the average of their values in each year
between 2003 and 2005 (the previous survey year is 2002).
The pooled ordinary least squares (OLS) estimation used in our analysis can poten-
tially suffer from simultaneity or omitted variable problems. For example, the regulatory
and supervisory framework of an economy can be implemented for promoting financial
development and economic stability and growth. To avoid this reverse causality problem,
we use the average of explanatory variables for the past years since the previous survey,
 80 Emerging Markets Finance & Trade

excluding the current year. This approach assumes that any indicators of previous years
are not correlated with unobserved shocks that would affect the regulation indexes of
the current year, and therefore are predetermined. In addition, to mitigate the possible
endogeneity problem that may arise from unobserved country-specific factors, we control
for income and region of the sample countries using the panel structure of our data.
The unobserved disturbance, εit, is composed of three components: country-specific
characteristic (µi ), time-specific unobservables (λt ), and idiosyncratic error (hit ). Cor-
relation of µi with any explanatory variable gives rise to an omitted variable problem.
Performing the Hausman test does not support the endogeneity of unobservable µi in most
cases. To accommodate possible correlation across the error terms, we use the random
effects models and compare them with the pooled OLS results. Time-specific unobserv-
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ables are captured by year dummies. Since most of the indexes in our analysis are based
on ordinal outcomes, one may think that the ordered multinomial models provide an
adequate approach. As a robustness check, we report in the tables below the estimates
from the random effects ordered probit for the ordinal indexes.8 For all the indexes, the
signs, relative magnitudes, and statistical significance of the estimated coefficients are
nearly the same as those from the random effects panel model.

Results

Regulation of Banking Activities

Table 4 presents the regression results for the regulation of banking activities. The first
three columns report the results for the regulation of overall banking activities; the next
six columns report the results for two specific components of the banking-activity index:
nontraditional banking services and bank ownership. We report the results of pooled
OLS, random effects panel, and ordered probit models.9 Subsequent tables report key
variables such as financial crisis, income, and time dummies and statistically significant
variables, among others.
The results show regulation of banking activities to be tighter in countries with lower
income and high inflation rates. This is consistent with the fact that more-stable and
higher-income economies are more inclined to allow universal banking services than
are emerging and developing countries in which financial markets are relatively under-
developed and traditional banking services are central to the economy. The variable of
financial crisis is not statistically significant, but low- to middle-income economies tend
to be lenient regarding the scopes of bank activities as they have experienced longer
periods of crisis. It is also notable that regulation of banking activities, which was less
restrictive in 1999 and 2002, became tighter in 2006 but was loosened again in the latter
half of the first decade of the 2000s.10 Regarding the individual index of restrictions on
nontraditional banking activities, regulation is stricter as governments suffer larger budget
deficits, ROE is higher, and banks have higher credit-to-deposit ratios. A political factor
emerges in ownership restriction, with stricter regulation imposed in countries in which
party orientation turns left with respect to economic policy.11

Regulation of Capital Requirements

The determinants of capital regulation are presented in Table 5. Overall capital regulation
tends to be more restrictive as the size of financial markets (measured by the ratio of
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Table 4. Determinants of regulation of bank activities

Overall bank activity regulation Activity restriction Ownership restriction

Pooled Random Ordered Pooled Random Ordered Pooled Random Ordered

Variables OLS effects probit OLS effects probit OLS effects probit

Financial Crisis (years) 0.0322 0.0233 0.00754 0.0881 0.0789 0.0598 –0.0542 –0.0565 –0.0480
Middle-Low income 1.063* 0.925 0.530 0.608* 0.501 0.399 0.444 0.385 0.313
Financial Crises × Mid- –0.254** –0.184 –0.0882 –0.245*** –0.201** –0.157** 0.00688 0.0293 0.0219
Low income
Year 1999 (dummy) –0.982** –0.808** –0.399** 0.104 0.136 0.0826 –1.054*** –0.923*** –0.761***
Year 2002 (dummy) –0.442 –0.358 –0.180 0.282 0.293 0.216 –0.650*** –0.573*** –0.479***
Year 2006 (dummy) 0.919** 1.011*** 0.498*** 1.129*** 1.159*** 0.883*** –0.239 –0.151 –0.137
Inflation 0.0508*** 0.0661*** 0.0327*** 0.0379*** 0.0475*** 0.0361*** 0.0116 0.0180* 0.0152*
Government balance to –0.0783** –0.0498 –0.0209 –0.0749*** –0.0525** –0.0419** 0.00638 0.00580 0.00317
GDP (percent)
Right turn –0.0864 –0.171 –0.0827 –0.112 –0.103 –0.0825 –0.126 –0.0895 –0.0929
Left turn 0.948 0.710 0.387 –0.454 –0.607 –0.510 1.388* 1.324** 1.089**
ROA 0.0549 0.0916 0.0435 0.0629** 0.0793** 0.0584** –0.00887 0.00525 0.00370
ROE 0.00374 0.00382 0.00163 0.00540** 0.00402 0.00296 –0.00171 –0.000822 –0.000640
Credit to deposit 0.00209 0.00509 0.00236 0.00537** 0.00551** 0.00423** –0.00248 –0.000372 –0.000146
(percent)
Constant 11.83*** 11.06*** 5.485*** 5.204*** 6.325*** 5.989***
Observations 394 394 394 408 408 408 404 404 404
R2 0.305 0.342 0.207

Notes: Region dummies are included. Robust standards are used in all regressions. * p < 0.1; ** p < 0.05; *** p < 0.01.
81
 82 Emerging Markets Finance & Trade

Table 5. Determinants of capital regulations

Overall capital regulation Capital stringency

Pooled Random Pooled Random Ordered
Variables OLS effects OLS effects probit
Financial Crisis –0.0722 –0.0312 –0.0430 –0.0983 –0.0673
(years)
Middle-Low income 0.458 0.622 0.187 0.218 0.161
Financial Crisis × 0.0269 –0.0105 0.0609 0.109 0.0762
Mid-Low income
Year 1999 (dummy) –1.782*** –1.652*** –1.328*** –1.360*** –0.992***
Year 2002 (dummy) –1.457*** –1.350*** –1.385*** –1.325*** –0.958***
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Year 2006 (dummy) –1.815*** –1.678*** –1.763*** –1.672*** –1.184***

Inflation 0.000325 0.00122 0.00567 0.00832 0.00650
Credit to GDP 0.0211** 0.0187** 0.00390 0.00215 0.00127
(percent)
Right turn –2.260** –2.245* –0.935 –0.925 –0.639*
Left turn 0.903 1.814 1.285 1.296* 0.915*
Overhead costs 0.187** 0.115 0.129*** 0.101* 0.0719*
ROA 0.201*** 0.192*** 0.0796*** 0.0709* 0.0559**
ROE 0.00681* 0.00579 0.00474 0.00292 0.00209
Credit to government –0.0119 –0.00805 0.0184 0.0221* 0.0155*
(GDP percent)
Credit to deposit –0.0125** –0.00908 –0.00118 0.000421 0.000292
(percent)
Commonwealth 1.054** 1.084* 0.184 0.315 0.236
Constant 8.276*** 7.975*** 6.693*** 7.024***
Observations 200 200 406 406 406
R2 0.354 0.214

Notes: Region dummies are included. Robust standards are used in all regressions. * p < 0.1;
** p < 0.05; *** p < 0.01.

private credit to GDP) grows and banks have higher ROA and ROE. This suggests that
countries with more-developed and more-efficient financial sectors require more-stringent
capital regulation. One possible explanation is that such countries set high standards for
capital regulation to assure investors of the stability of the banking sector. Moreover,
economies with a high credit-to-GDP ratio are likely to have a relatively large population
of international banks and thus greater capital regulation stringency in accordance with
higher global standards. Regulation is more restrictive when banks have inefficient cost
structures. Overall capital regulation and capital stringency are more restrictive in 2011
than in 1999, 2002, and 2006, reflecting the widespread trend of enforcing high standards
for capital requirements in the wake of the global financial crisis of 2008.

Private Monitoring Requirements

Table 6 reports results for private monitoring requirements. In the indexes for overall
private monitoring and for external ratings and creditor monitoring, low- to middle-income
economies are shown to be less stringent with regard to private monitoring obligations.
This relates to emerging and developing economies’ lack of capacity to maintain adequate
standards for private monitoring. Weak institutional structure, lack of human capital,
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Table 6. Determinants of private monitoring requirements

Overall private monitoring External ratings/creditor monitoring

Pooled Random Pooled Random
Variables OLS effects Ordered probit OLS effects Ordered probit
Financial Crisis (years) 0.0639 0.0696 0.0701 –0.0401 –0.0307 –0.0356
Middle-Low income –0.762*** –0.892*** –0.803*** –0.853*** –0.692 –0.596
Financial Crisis × Mid-Low income 0.0699 0.0598 0.0465 0.165*** 0.140 0.118
Year 1999 (dummy) –0.0919 –0.115 –0.105 –0.941*** –0.921*** –0.739***
Year 2002 (dummy) 0.300 0.286 0.271* –0.398* –0.304* –0.256
Year 2006 (dummy) 0.194 0.186 0.181 –0.243 –0.155 –0.107
Inflation –0.0140* –0.0105 –0.0104 –0.0245** –0.0157* –0.0101
Credit to GDP (percent) 0.00453* 0.00401 0.00391 0.00454* 0.00530 0.00489*
Government vote (percent) –0.0102*** –0.00965** –0.00948*** –0.00951** –0.0100** –0.00841**
Opposition vote (percent) 0.0129*** 0.00943* 0.00998** 0.00313 0.00313 0.00109
Overhead costs 0.0653 0.0609 0.0597 0.109** 0.0414 0.0334
Commonwealth 0.260 0.225 0.209 0.552** 0.512 0.450*
Constant 7.236*** 7.390*** 12.55*** 12.28***
Observations 371 371 371 425 425 425
R2 0.267 0.196

Notes: Region dummies are included. Robust standards are used in all regressions. * p < 0.1; ** p < 0.05; *** p < 0.01.
83
 84 Emerging Markets Finance & Trade

underdeveloped private sector, and asymmetric information problems impede proper

functioning of private monitoring in such economies. However, relative to high-income
countries, low- to middle-income economies have a greater tendency to reinforce external
rating and creditor monitoring subsequent to financial crises. This seems reasonable given
that elaborate institutional structures and high standards for private monitoring systems
are already established in high-income countries.
High inflation is negatively correlated with the extent to which private monitoring is
required by regulation. This implies that stable economies tend to encourage or enforce
private monitoring and external ratings. The results with pooled OLS show that the regu-
latory system is likely to encourage monitoring and evaluation of banks by creditors and
external rating agencies as the size of the financial market increases. This relates to econo-
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mies of scale in the production of information required to support bank monitoring.

Regulation of Market Entry

Table 7 reports the results for the regulation of market structure. The restriction on bank
market entry is more stringent in low- to middle-income economies. Taken together
with other results, this reveals a contrast in regulatory philosophies across countries with
different income levels. Low- to middle-income countries rely more on ex ante entry
permissions; high-income economies use ex post regulatory measures such as capital
regulation and private monitoring. We also find that restrictions on bank licensing and
foreign bank entry became more stringent in 2011 compared with the late 1990s and the
first decade of the 2000s. This reflects regulatory authorities’ concerns that too much
competition in the banking sector would encourage excessive risk taking and lower
overall quality of loans.

Supervisory Power
Table 8 presents the results for supervisory power and independence. Supervisory
authority is more independent of political interests in low- to middle-income countries,
which is counterintuitive. Regulatory authorities in such countries have less supervisory
discretion, which implies that there is a legal requirement for supervisory action when
indicators of bank soundness fall to a certain threshold and that supervisory authority is
forbidden to waive regulatory requirements. The discretionary power of its supervisory
authority is attenuated when an economy endures a protracted financial crisis. This is
reversed, however, for low- to middle-income economies. One possible interpretation of
these results is that low-income economies rely on rules-based regulatory regimes, which
is consistent with a lower level of supervisory discretion; however, after financial crises,
they tend to facilitate greater flexibility in supervisory enforcement by granting more
discretion to protect their underdeveloped financial systems from external shocks.
Another notable trend, following the 2008 financial crisis, is the diminution of
supervisory power and discretion and concomitant strengthening of the independence
of supervisory authorities. That supervisory authorities become more powerful and
less independent as the size of credit to the government grows suggests that their inde-
pendence is likely to increase as the financial sector becomes more independent of the
government. The results also show supervisory power and independence to decline as
banks rely heavily on noncore liabilities for funding (measured by the credit-to-deposit
ratio). With respect to political variables, there being an executive election since the pre-
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Table 7. Determinants of regulation of market entry

Requirements for market entry Restriction on foreign banks

Pooled Random Pooled Random

Variables OLS effects Ordered probit OLS effects Ordered probit

Financial Crisis (years) 0.0151 0.0191 –0.0113 –0.0186 –0.0238 –0.309

Middle-Low income 0.440** 0.477** 0.958** 0.257* 0.151 1.251
Fin. Crisis × Mid-Low income –0.0210 –0.0246 0.0235 0.00617 0.0174 0.342
Year 1999 (dummy) –0.320** –0.338*** –0.788*** –0.229** –0.203*** –1.137***
Year 2002 (dummy) –0.341*** –0.351*** –0.769*** –0.163* –0.178*** –0.792***
Year 2006 (dummy) –0.104 –0.107 –0.133 –0.0739 –0.107** –0.570**
Inflation –0.000430 –0.000188 –0.00123 9.47e–06 0.000803 0.00518
Government vote (percent) 0.000612 0.000501 0.000691 –0.00452*** –0.00100 –0.00844
Constant 7.614*** 7.589*** 0.566** 0.281
Observations 456 456 456 439 439 439
R2 0.116 0.171

Notes: Region dummies are included. Robust standards are used in all regressions. * p < 0.1; ** p < 0.05; *** p < 0.01.
85
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86

Table 8. Determinants of supervisory power

Supervisory power Supervisory independence Supervisory discretion

Pooled Random Ordered Pooled Random Ordered Pooled Random Ordered

Variables OLS effects probit OLS effects probit OLS effects probit

Financial Crisis (years) 0.0844 0.179 0.0933 0.0428 0.0442 0.0801 –0.105*** –0.0787* –0.110*
Middle-Low income 0.312 0.907 0.491 0.333* 0.340 0.698* –0.270 –0.203 –0.260
Fin. Crisis × Mid-Low 0.00979 –0.113 –0.0500 –0.00338 –0.0128 –0.0147 0.106** 0.0765 0.107
income
Year 1999 (dummy) 0.580 0.563* 0.286 –0.126 –0.204* –0.411* 0.317** 0.350*** 0.506***
Year 2002 (dummy) 0.536 0.514* 0.341** –0.252** –0.292*** –0.573*** 0.397*** 0.388*** 0.553***
Year 2006 (dummy) 0.791** 0.849*** 0.493*** –0.229** –0.269*** –0.530*** 0.306** 0.290*** 0.455***
Inflation –0.00324 –0.000760 0.000779 –0.00585* –0.00835* –0.0151* 0.000226 –0.00127 –7.08e–05
Credit to GDP (percent) 0.00480 0.00371 0.00166 0.00225* 0.00129 0.00309 0.000974 0.000981 0.00160
Executive election 1.202* 0.538 0.223 0.0492 –0.0349 –0.0594 –0.550** –0.444* –0.716*
Right turn –1.412* –1.129 –0.593 –0.441 –0.294 –0.542 –0.0442 0.0186 0.0479
Left turn 1.099 1.149 0.684 0.0642 0.00995 0.0400 –0.372 –0.332 –0.620
Overhead costs 0.174*** 0.119* 0.0495 –0.0136 –0.0359 –0.0639 –0.0738*** –0.0588** –0.0848**
Operating costs –0.0197** –0.00932 –0.00327 –0.00311 –0.00229 –0.00530 0.000437 0.000925 0.00114
Credit to Government 0.0273** 0.0379** 0.0223** –0.0144*** –0.0128** –0.0255** 0.00579 0.00545 0.00840
(GDP percent)
Credit to deposit –0.00660** –0.00466 –0.00254 –0.00373*** –0.00364*** –0.00706*** 0.000492 0.00149 0.00202
(percent)
Commonwealth 0.626* 0.620 0.355 0.502*** 0.463*** 0.903*** 0.127 0.151 0.224
Constant 11.60*** 10.41*** 2.669*** 2.702*** 1.692*** 1.444***
Observations 440 440 440 377 377 377 437 437 437
R2 0.139 0.249 0.186

Notes: Region dummies are included. Robust standards are used in all regressions. * p < 0.1; ** p < 0.05; *** p < 0.01.
 November–December 2014 87

vious survey is correlated with more supervisory power but less discretion, and a party
orientation turning right with respect to economic policy is correlated with a reduction
in supervisory power.

Conclusion
In this paper, we identify multiple aspects of banking regulation and their respective
determinants. We find incentives for forming and restructuring regulatory frameworks to
differ between developed and emerging economies. We also find that financial markets
in advanced economies, although further developed in many respects, do not necessar-
ily exhibit overall deregulation. This reflects the positive potential of regulation to not
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only protect economies from crisis, but also help financial institutions attract investors
by ensuring stability. Moreover, different aspects of bank regulation vary significantly
in degree of deregulation, suggesting that the roles of bank regulations are intertwined.
Further analysis of interactions among banking regulations will provide useful guidance.
We leave this to future research.

Notes
1. Barth et al. (2004) use the World Bank survey to identify regulatory policies enhancing
bank development and stability. Neyapti and Dincer (2014) examine the effects of bank regulation
on bank performance, with an emphasis on legal frameworks. Demirgüç-Kunt and Detragiache
(1998) provide empirical evidence that liberalized financial markets are vulnerable to banking
crises. Levine (2001) examines the effects of liberalization on long-term economic growth, and,
more recently, Kim et al. (2013) analyze the relationship between banking regulation, decomposed
into multiple aspects, and financial crisis.
2. In the United States, regulation of universal banking dates back to the Glass-Steagall Act
of 1933, which required separation of commercial and investment banking. The separation was
removed in 1999 by the Gramm-Leach-Bliley Act. However, in 2013, in the wake of the 2008 fi-
nancial crisis, the Volcker Rule, the provision of the Dodd-Frank Act that bars banks from engaging
in proprietary trading activity, was approved.
3. Following a financial crisis in the late 1990s, Korea’s financial sector underwent extensive
structural reforms. This restructuring was implemented along different tracks across various dimen-
sions of regulations. Whereas reforms along most dimensions aimed to restore financial stability,
the regulation on banking activities was directed at promoting greater efficiency and universal
banking. Legislation such as The Financial Holding Companies Act in 2000 and The Financial
Investment Services and Capital Market Act in 2007 enabled banks to engage, via financial holding
companies, in a broader range of financial services including securities transactions, asset manage-
ment, and the insurance business. At the same time, the government established a stronger, more
independent supervisory system by integrating the formerly segregated supervisory agencies of
the banking, securities, and insurance markets. Moreover, capital regulations, in accordance with
the Basel standard, were amended to reflect more-accurate measures of risk and strengthen the
requirements for information disclosure.
4. We standardize the index based on numeric variables using standard deviations.
5. ROA and ROE may depend on the extent of asset or equity accumulation. For example,
ROA or ROE can be high when the economy is in an early stage of financial development, hence
high marginal returns. However, these variables are generally adequate measures of efficiency if
other factors are properly controlled.
6. Hahm et al. (2012) find evidence that measures of noncore liabilities serve as an effective
indicator of vulnerability to currency and credit crises when credit expands rapidly.
7. Studies by Abiad and Mody (2005) and Rajan and Zingales (2003) reflect a political economy
perspective on financial development and liberalization.
8. The stringency of loan classification and provisioning, which constitutes the overall capital
regulation index, is a pure number index. Therefore, the estimation for this index is not reported.
 88 Emerging Markets Finance & Trade

9. For the panel analysis, we perform the Hausman test, for all indexes, to choose between
fixed and random effects models. It shows that the error terms in the models are not significantly
correlated with country-specific unobserved factors; therefore, the random effects model is suitable
for our panel analysis (Hausman 1978).
10. Note that the base group of time dummy variables is the year 2011.
11. Party orientation with respect to economic policy is categorized as Right for parties defined
as conservative, Christian, or right-wing, and Left for parties defined as communist, socialist, social
democratic, or left-wing.

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