Bank Supervision Russian Style:Bank Supervision Russian Style:Evidence of conflicts between micro- and macro-prudential objectivesEvidence of conflicts between micro- and macro-prudential objectives

Sophie Claeys Sophie Claeys

Koen SchoorsKoen Schoors

May 2007May 2007

MotivationMotivation

•Not about bureaucrats versus politicians•Not about turf wars between agencies•Not about conflict between regulation and supervision•But about goal conflict within agencies•Two goals under scrutiny

‣Systemic stability (macro-prudential)‣Individual bank stability (micro-prudential)

Conflicts of interestConflicts of interest

Bank Supervision

Deposit Insurance

Management international reserves

Monetary policy

Central Bank

Lender of last resort

-Money emission

-Management of the payments system

Inflation versus systemic stabilityInflation versus systemic stability

Exchange rate versus inflation oriented policy

Exchange rate versus inflation oriented policy

Systemic versus individual bank stabilitySystemic versus individual bank stability

Deposit insurance versus individual bank stability

Deposit insurance versus individual bank stability

Conflicts of interestConflicts of interest

Bank Supervision

Deposit Insurance

Management international reserves

Monetary policy

Central Bank

Lender of last resort

-Money emission

-Management of the payments system

Inflation versus systemic stabilityInflation versus systemic stability

Exchange rate versus inflation oriented policy

Exchange rate versus inflation oriented policy

Systemic versus individual bank stability

Systemic versus individual bank stability

Deposit insurance versus individual bank stability

Deposit insurance versus individual bank stability

Short term conflict between objectivesShort term conflict between objectives

•Systemic versus Individual bank stability‣Central Banks reponsible for systemic stability‣Lender of Last Resort function (LLR)‣Creates Moral Hazard‣Need for prudential regulation / bank supervision

‣Strict enforcement of rules systemic stability

‣The consequence may be forbearance

•Dynamic inconsistency between rule-based supervision and systemic stability?

LiteratureLiterature

Theoretical literature touches on these conflicts of interest‣Bagehot (1873):‣Goodhart and Huang (1999): constructive ambiguity‣Cordella and Yeyati (2003): contingent ex ante commitment‣Freixas et al. (2000): forebearance towards money-center banks‣Kahn and Santos (2005): endogenous forbearance

More obscure reasons for forbearance‣Boot and Thakor (1993): reputation seeking supervisors‣Wall and Peterson: too big to fail ‣Kane (2000): too big to discipline adequately‣Mitchell (1999): too many to fail‣Heineman and Shüler (2004): regulatory capture

Why RussiaWhy Russia??

•CBR has all authorities and owns important commercial banks

‣LLR‣Banks supervision and control‣Monetary policy and exchange rate policy‣no turf wars and ample scope for conflicts of interest

•CBR designs and enforces the rules‣No regulation versus supervision problem

•Enforcement is measurable‣Although we do not observe fines etc,‣We do observe license withdrawals, i.e. the ultimate

sanction for repeated and/or severe breaches

Bank creation and destructionBank creation and destruction ( (monthly datamonthly data))

peak of 347 banks in November 1990

Why 1999-2002 ?Why 1999-2002 ?

•April 1996: Revised set of prudential regulations•1998: move away from RAS towards IAS•August 1998 quadruple crisis

‣pre and post crisis data are difficult to compare

•March 1999: new law on bank restructuring‣central role of CBR in licensing behaviour‣Focus on bank license behaviour of the CBR:

•Later there is a new crisis (2004) and the introduction of deposit insurance (2005)

Empirical approachEmpirical approach

Analyze enforcement of prudential regulations‣Dependent variable is license revokal‣Control for economic variables that explain bank failure‣Control for tacit CBR objectives (systemic stability)‣Enforcement is measured as the impact of non- compliance with

bank standards on license revokal

Hypothesis I: ”De-licensing is driven by micro-prudential concerns”

Hypothesis II:”Micro- and micro-prudential concerns do not conflict”

Micro-prudential concerns: the bank standards?Micro-prudential concerns: the bank standards?

•N1 or the capital adequacy ratio •N2 or the instant liquidity ratio •N3 or the current liquidity ratio •N4 or the long-term liquidity ratio•N5 or the general liquidity ratio•N7 or maximum large credit risk•N9.1 or maximum risk per borrower-shareholder•N10.1 or maximum credit to insiders •N11, minimal coverage of household deposits by capital•N12 or minimal coverage by the bank’s investments in shares by capital•N13 or the bank’s own promissory notes liability risk ratio

How to measure enforcement?How to measure enforcement?

Principles of Compliance measuresPrinciples of Compliance measures

We observe bank compliance to regulatory standards:‣Every quarter banks report scores on the bank standards

‣We know the time-varying regulatory threshold for every standard

‣This allows the identification of time and bank specific breaches

‣We use this information to construct measures for bank compliance to regulatory standards

‣We value current breaches higher than past breaches

‧CBR cares more about current than past breaches

‧Still past breaches are not totally forgiven

Compliance measures ICompliance measures INumber of breachesNumber of breaches

•Define for every bankquarter the standard-specific breaches (score exceeds threshold)

•Each bank i has a number of breaches, defined as:

•We discount past breaches using and construct:

1

(1 ) , 1tt t

t

)()( 0,,

PR

t

kz z

tin ttkt

breachnbreach

, , 0( )( )t PR

n i t t z zz kdnbreach breach t t

Compliance measures IICompliance measures IIAverage severity of breachAverage severity of breach

•One-sided average severity of breach defined as

•We discount past breaches using

and construct:

•We also create a dummy if standards are not reported

1

(1 ) , 1tt t

t

standardstandard

, , ( )

z z

z

t score

z kn i tsbreach

t k

standard, , standard( )z z

z

t scoren i t tz k

dsbreach

Macro-prudential objectivesMacro-prudential objectives

Regional banking coverage or minimal competition‣Regional Herfindahl index

Political influence‣Share of government claims in assets – government capture‣Government ownership‣Pocket-banks – political incentives to show forbearance for bank

standards N9.1 and N10.1.

Systemic stability‣Size (TBTF or TBTDA)‣Too many too fail‣Money center banks (interbank liabilities)‣Protect deposit banks – forbearance for N11 (household deposits over

capital)

Economic fundamentalsEconomic fundamentals

•Return on assets•Cost/assets•Interbank liabilities/liabilities•Regional market share (assets)•Non performing loans/loans•Reserves/assets•Government bonds/assets

The dataThe data

Registration data of the CBR‣Complete database available from CBR‣All banks (1988 till now), All licensing data (when received, type,

when revoked, reason for revocation)

Interfaks database from 1999 up till 2002‣Quarterly bank balances, profit and loss data, ‣Quarterly bank specific scores on every standard 99-02

Mobile database‣Quarterly bank specific scores on standards 97-99, for calculation of

compliance variables only

Hypothesis IHypothesis I

-

+

Hypothesis IIHypothesis II

-

+

-

Main findings IMain findings I

•Bank failures are sensibly related to economic variables ‣Efficiency‣Loan quality‣Reserves

•Macro-prudential objectives matter: Banks are less likely to face license revokal IF

‣They are in highly concentrated regional bank markets‣They are large‣They are money center banks‣There are too many failing banks

Main findings IIMain findings II

•There is some level of enforcement of bank standards‣Capital adequacy standards‣Liquidity standards, but is his good news?‣Insider bank standards

•Forbearance is related to systemic stability issues‣Offenders of liquidity standards are not punished in poorly banked

regions‣Frequent offenders of capital adequacy get away if they are large‣Severe liquidity shortages are forborne if they are too many banks too

fail.‣But frequent offenders are punished in that case.

Concluding remarksConcluding remarks

•Not all is bad in Russian bank supervision•But

‣Need to think about appropriate role for CBR‣Doing everthing implies doing nothing perfect

•The found conflict may be a general problem‣Further work in other develping markets needed