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...Basel Committee on Banking Supervision, are one of the most important standards, largely because of the dominant position banks have in many financial systems as well as the potentially serious macroeconomic consequences of banking instability. (2)
The International Monetary Fund (IMF) and the World Bank have been leading the BCP compliance assessments, mostly in the context of the Financial Sector Assessment Program (FSAP). (3) The BCP assessments have been among the most rigorous, with detailed Core Principles Methodology, two assessors conducting each assessment, and a thorough review of the draft assessment to ensure consistency. Arrangements with cooperating supervisory agencies and central banks have ensured the participation of experienced experts in the assessments.
The introduction of international financial standards and the first assessment results have understandably generated interest in exploring the relationship between the observance of standards and the functioning of the financial sector. Recent work includes papers by Christofides, Mulder, and Tiffin (2003), who studied the impact of the observance of a variety of standards on spreads and ratings; Das, Quintyn, and Chenard (2004), who explored the link between financial sector soundness and regulatory governance; and Glennerster and Shin (2003), who focused on the effects of transparency on borrowing costs.
Despite the considerable attention the BCP has received in FSAPs and other IMF work, there is limited evidence about the relationship between compliance with the BCP and performance of the banking system. An initial attempt to explore this link was offered by Sundararajan, Marston, and Basu (2001). Their paper presented an empirical examination of the relationship between compliance with BCP (measured by a BCP noncompliance indicator constructed from the results of BCP assessments) and nonperforming loan (NPL) ratios and spreads between lending and risk-free rates. Their results suggested that BCP noncompliance had no direct effect either on the level of NPLs or on the level of lending spread, but that it could influence credit risk and soundness indirectly through its interaction with other macroeconomic and banking sector factors. The analysis provided by Sundararajan, Marston, and Basu (2001) should be considered preliminary because of the rather severe limitation of data then available. Separately, Barth, Caprio, and Levine (2002) examined the relationship between specific regulatory and supervisory practices and banking sector development, efficiency, and fragility and found little evidence of any impact of official supervisory power or bank activity restrictions on interest margins or NPLs. (4)
This paper reexamines the relationship between banking sector performance and the quality of regulation and supervision, as measured by compliance with the BCP. The basic question we address is whether following the BCP creates a regulatory and supervisory environment that helps improve banking sector performance. We use two of the common measures of banking sector performance: NPLs and net interest margin. The level of NPLs reflects the degree to which banks are able to perform one of their basic functions, that is, collect the money they lend. While there may be different reasons for an increase in NPLs, a high level of NPLs almost universally indicates serious problems in the banking sector. Net interest margin can be interpreted as a measure of the efficiency of banking sector performance, because it indicates the cost of banking intermediation that needs to be paid by banks' customers. (5)
We use a new data set and different methodology than previous literature. Using panel data from 1998 to 2002, we estimated a model explaining the variation of the ratio of NPLs across 65 countries that went through the BCP assessment. Data from the 1998-2001 World Bank financial system structure database were used to estimate a model of net interest margin for the same set of countries. We include an index of BCP compliance in both models to explore whether BCP compliance has any measurable impact on banking sector performance after taking into account other determinants of NPLs and net interest margin.
Our results suggest that a higher degree of compliance with the BCP has a significant positive impact on asset quality of banks (as measured by the ratio of NPLs), even after taking into account the level of development of the economy and macroeconomic factors. We also find evidence that a higher degree of compliance with the BCP is associated with lower net interest margin. An effort to improve compliance with the BCP should therefore have a positive impact on banking sector performance across countries. (6)
I. Models and Data Description
BCP Compliance
We constructed a simple index of overall BCP compliance from assessments conducted mostly during FSAPs. (7) We use detailed information about each assessment, including a four-grade rating for each core principle. (8) For the 65 countries in our sample, we have assigned values to assessment grades--compliant (4), largely compliant (3), materially noncompliant (2), and noncompliant (1). (9) The value of the index of overall compliance for a given country is equal to the sum of ratings for individual core principles. (10) Therefore, the actual values of the index of overall BCP compliance will be between 30 and 120, with higher values indicating a higher degree of compliance. (11)
[FIGURE 1 OMITTED]
Our sample includes 13 advanced countries, 19 emerging market countries, and 33 developing countries. Figure 1 confirms that advanced countries achieved the highest level of BCP compliance, followed by emerging and developing countries. The variance of results, as measured by the difference between best and worst results in each group, also increases from advanced countries to emerging countries, and further to developing countries.
We also construct several subindices of BCP, using different groupings of the Core Principles and using the same procedure as described above for the overall BCP compliance. These include (1) objectives, autonomy, and powers of the supervisor; (2) licensing and structure; (3) prudential regulations; (4) methods of ongoing supervision; and (5) cross-border banking. (12) The correlation matrix of these subindices presented in Table 1 suggests that the assessment results of the parts of BCP are rather closely correlated.
A higher degree of compliance appears to be associated with lower NPLs and narrower net interest margin. Figures 2 and 3 show that actual BCP compliance exhibits a considerable variation in our sample, from the perfect score of 120 to a rather low value of just over 50. The two measures of banking performance show substantial variation across the sample. There appears to be a negative relationship between BCP compliance and the two banking measures, with high compliance being associated with more favorable outcomes--that is, lower NPLs and narrower margins. This relationship appears to be tighter for countries with higher compliance, because the dispersion of observations increases with decreasing compliance--this holds for both NPLs and net interest margin.
Model of NPLs...
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