Basel regulations and banks’ efficiency: The case of the Philippines

Accepted Manuscript Title: Basel regulations and banks’ efficiency: The case of the Philippines Author: Maria Chelo V. Manlagnit PII: DOI: Reference:

S1049-0078(15)00052-4 http://dx.doi.org/doi:10.1016/j.asieco.2015.06.001 ASIECO 993

To appear in:

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Received date: Revised date: Accepted date:

30-8-2014 11-6-2015 18-6-2015

Please cite this article as: Manlagnit, M. C. V.,Basel regulations and banks’ efficiency: The case of the Philippines, Journal of Asian Economics (2015), http://dx.doi.org/10.1016/j.asieco.2015.06.001 This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting proof before it is published in its final form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.

*Highlights (for review)

Highlights 

The Philippine commercial banks exhibit substantial cost inefficiencies averaging to 25% of total costs. Higher capital requirement (pillar 1) tends to improve the cost efficiency.

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More powerful supervisors (pillar 2) can adversely affect the cost efficiency of the banks.

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Market discipline (pillar 3) is not significant in explaining cost efficiency of the banks.

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Other potential correlates of inefficiency are risk and asset quality and bank-specific variables.

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*Manuscript

Title

Basel regulations and banks‟ efficiency: The case of the Philippines

Author

Maria Chelo V. Manlagnit

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Ph.D. Economics (2009)

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Department of Economics, University of Hawai„i at Mānoa (2004‒ 2009) 2424 Maile Way, Saunders 542 Honolulu, HI 96822

Email

[email protected]

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1(808)203-4181

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Telephone

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East-West Center Fellow (2004‒ 2008) 1601 East-West Road Honolulu, Hawai„i 96848 USA

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Affiliations

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Postal Address 3037A Kahaloa Drive Honolulu, Hawaii 96822 USA

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Basel regulations and banks’ efficiency: The case of the Philippines

1

Introduction

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Regulatory change, due to unprecedented changes and reforms on financial institutions and markets around the globe, has greatly affected the efficiency of financial institutions in recent years. More particularly, the weaknesses in financial regulation and supervision have been pointed out by several

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studies as one of the factors leading to the recent global financial crisis that started in late 2007 (Dan 2010; Lawrence 2010; Levine 2010; Merrouche and Neir 2010; Barth, Caprio and Levine 2012). The

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recent global financial crisis, as a consequence, did not only bring up critical questions on the appropriateness of the current regulatory and supervisory approaches, but also prompted regulators to take

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into account the important changes in regulation and supervision. In response to the recent crisis, several countries are in the process of strengthening their regulatory and supervisory systems to improve crisis prevention and management.

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Financial regulation and supervision, particularly in the banking sector, is often considered a controversial issue. However, since banks play a major role in the well-being of the economy, there is a substantial need for developing public policies that enhance bank operations. As such, most countries in

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the world are eager to adopt the “best practices” for the regulation and supervision of banks advocated by

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the Basel Committee on Bank Supervision (BCBS), making them almost universal standards for bank regulators. For example, virtually all countries adopted the 1988 Basel Capital Accord (Basel I) and in

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2004, within three months of its official announcement, more than one hundred countries already signaled their intention to adopt Basel II (Barth, Caprio and Levine 2006). Basel II, which is the revised and extended version of Basel I, is based on three main pillars: minimum capital requirements, supervisory review and market discipline. Basel II was expected to produce significant benefits in helping banks and supervisors manage risks, improve stability and enable market participants to make better risk assessments (Molyneux 2003). However, the recent global financial crisis has revealed many shortcomings of the Basel II Accord that prompted the urgency of a revised capital adequacy framework.1 In 2010, the new proposed framework, Basel III, was issued. This new framework revises and strengthens the three pillars established by Basel II. However, as pointed out by Demirguc-Kunt, Detragiache and Tressel (2008), upgrading bank regulation and supervision is a complex and difficult process especially in developing countries where the required expertise may be scarce, the legal environment weak and governance problems may lead to regulatory capture. 1

In 2009, to address the lessons of the crisis related to the regulation, supervision and risk management of global banks, the Basel Committee approved for consultation a package of proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector (see BIS 2009).

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The efficiency of banking institutions has already been reported considerably in the literature, with most studies concentrated in the United States (US), and an increasing trend toward studies on European financial institutions. This increasing trend seems to be partly motivated by the existing literature on growth and finance that suggests that the overall economic success of a country is positively

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related to its financial sector development (e.g., Levine 1997; Levine and Zervos 1998; and Rajan and Zingales 1998, among others). The Philippine banking system is of particular interest for examining efficiency and risk issues since it experienced substantial banking reforms since the 1990s, after being a

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tightly regulated banking system. It is interesting to note that according to the series of World Bank surveys from 1999 to 2012, the Philippines is among the top countries that advocate regulatory changes

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particularly on bank capital regulation and at the same time, has the highest increase in restrictions on bank capital (Barth, Caprio and Levine 2008, 2012).

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Using a stochastic frontier approach, the main objective of this study is to examine the impact of bank regulatory reforms, particularly the effects of the three pillars of Basel II on the cost efficiency of Philippine commercial banks with the goal of shedding light on how to prioritize efforts to improve

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supervision. More specifically, did the bank regulatory framework prescribed by the BCBS increase the efficiency of commercial banks? Answer to this question will help the country adjust its reforms and choose more appropriate reform strategies considering the significant increase in the demand for

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regulation after the recent global financial turmoil. Using the methodology proposed by Battese and

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Coelli (1995), this study will also identify possible determinants of efficiency of the banks. From a policy perspective, this study is motivated by Barth, Caprio and Levine (2012) regarding

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what policy to pursue using data from the extensive survey available. To the author‟s knowledge, this is the first paper that uses the World Bank survey data by Barth, Caprio and Levine (2004, 2006) and deals with evaluating the impact of implementing Basel II in the Philippines. In light of the newly implemented Basel III in the country last January 2014, it is imperative to know whether these regulations have positive impact on the efficiency of commercial banks. In effect, this paper also assesses the readiness of the commercial banks towards the implementation of Basel III in the country. Accordingly, this study will be informative to policymakers on the general direction in which to proceed with reforms (e.g., whether to emphasize capital requirements, bank supervision, or private monitoring) to improve and strengthen the country‟s commercial banking system. At the same time, this study is expected to help improve the regulatory and supervisory framework of the banking system in the country by identifying factors that could contribute to their efficiency. Moreover, this study uses comprehensive banking data compared to existing research on the effects of regulations on bank performance that typically relies on traditional measures of bank efficiency and performance derived from simple accounting ratios.

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The rest of the paper is structured as follows: Section 2 reviews the literature on banking efficiency particularly relating to Basel regulations. Section 3 briefly describes the Philippine banking system and the major financial reforms it recently underwent with respect to Basel regulations. Section 4 presents the empirical design for efficiency estimation, while Section 5 discusses the empirical results of

Review of literature

2.1

Bank Efficiency and Basel regulations

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the estimation and their implications. Section 6 concludes the paper.

Given the plethora of studies on the effects of regulatory and supervisory policies on banks‟

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performance, this section highlights the emerging themes from the extant studies on the effects of the three pillars of Basel II (capital requirements, supervisory power, and market discipline) on banks‟

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performance. Studies on this particular topic are still very limited in developing countries, in general and in Asian region, in particular.

Barth, Caprio and Levine (2001) provide one of the first studies on the empirical evidence of the

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effects of the three pillars associated with Basel II on bank performance. Using a series of surveys2 covering the period of 1999 to 2011, the authors‟ major findings remained consistent throughout the period covered: first, the stringency of capital regulations (pillar 1) and empowered supervisory agencies

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(pillar 2) are not closely linked with bank performance and stability; and second, regulations that

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encourage and facilitate private monitoring of banks (pillar 3) tend to boost bank performance. A related study of Dermiguc-Kunt, Detragiache and Tressel (2008) uses bank-level investor

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ratings for 39 countries to investigate whether compliance with the Basel Core Principles for Effective Banking Supervision (BCPs) improves bank soundness. The authors find that countries that require banks to regularly and accurately report their financial data to regulators and market participants have sounder banks. As such, the result emphasizes the importance of transparency in making supervisory processes effective and strengthening market discipline. Such policy recommendation is consistent with the study of Barth, Caprio, and Levine (2001, 2004, 2006, 2008, and 2012) that stresses the importance of mechanisms to empower market discipline (pillar 3) and is skeptical of structures that assign too much power to regulators (pillar 2).

Although still in its infancy stage, there are studies that examined the effects of Basel II on the efficiency of banks using parametric or non-parametric estimation techniques3. The study of Pasiouras

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The World Bank conducted an extensive survey of cross-country database on bank regulation and supervision. The first survey, Survey I, was done in 1999 covering 117 countries. This is followed by Survey II that described the regulation and supervision of 152 countries as of end-2002. Survey III characterized the regulatory situation of 142 countries as of 2005‒ 2006. The last survey, Survey IV, was completed in 2011 covering more than 125 countries. 3 See Berger and Humphrey (1997) for detailed discussion on these estimation techniques.

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(2008) using two-stage data envelopment analysis (DEA) in 95 countries in 2003 provides evidence in favor of all three pillars of Basel II in promoting banks‟ technical efficiency. In another study, Pasiouras, Tanna and Zopounidis (2009) examine the impact of regulations related to restrictions on bank activities and the three pillars of Basel II on cost and profit efficiency of banks using stochastic frontier analysis

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(SFA) in 74 countries during the period 2000‒ 2004. The findings are in favor of supervisory power and market discipline in increasing both the profit and cost efficiency; however, the results on capital requirements provide mixed results.

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A recent paper of Alam (2012) using DEA focuses on dual banking system in 11 countries over the period 2006‒ 2010 and examines the linkages between bank regulatory and supervisory structures

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associated with Basel II‟s pillars. The findings show that the efficiency of Islamic banks was positively influenced by regulations related to the second and third pillars while the efficiency of conventional banks

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was negatively influenced. The results also show that stricter regulations related to the first pillar had a positive impact on technical efficiency for both banks and that higher capital requirements induce lower level of risk behavior for both banks. Also, the findings on pillar 3 indicate that excessive private

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monitoring and regulatory restrictions on bank activities can affect the efficient operation of banks. In another study, using DEA, Chortareas, Girardone and Ventouri (2012) examine the dynamics between bank regulatory and supervisory policies associated with Basel II‟s three pillars and various aspects of

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banks‟ cost efficiency and performance on a selected sample of European commercial banks over the

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period 2000‒ 2006. The results show that empowering capital restrictions, fortifying official supervisory powers and private sector monitoring significantly impede the efficient operation of banks.

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Little is known on the effects of Basel II on the efficiency of Asian banks since empirical work is almost non-existing. The only extant study found by the author is done by Thangavelu and Findlay (2010). The authors examine the impact of bank regulation and supervision on the efficiency of banks from 1994 to 2008 employing a two-stage DEA. Their findings show that official supervision tends to improve the efficiency of the financial institutions in Southeast Asia but private monitoring does not produce positive impact on banks‟ efficiency. In summary, although many countries have followed the Basel guidelines, existing evidence on the impact of Basel II on bank efficiency is at best mixed. Given that the banking supervisors in the Philippines strongly advocate the implementation of Basel guidelines and yet, existing studies is still relatively scarce, focusing on this concern is long overdue. Thus, this paper will attempt to fill the gap in banking regulations and bank performance studies as it focuses on the analysis on Basel II and bank efficiency from a developing country perspective.

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2.2

Potential correlates of bank inefficiency From the limited available studies, the determinants of efficiency have been developed on an ad

hoc basis since there is no established theory on the factors explaining measured efficiency. For example, some studies find that ownership and location (Cebenoyan et al. 1993; Berger, Hasan and Zhou 2009;

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Barry et. al 2010); age, size, and type of the bank (Mester 1997; Manlagnit 2011); managerial control and/or organizational structure (Berger and DeYoung 2000; Okuda, Hashimoto and Murakami 2002; Valverde, Humphrey and del Paso 2007); and economic performance (Ferrier, 2001; Christopoulos et al.

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2002; Pasiouras, Tanna and Zopounidis 2009) as factors determinant of measured efficiency among

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banks.

Reforms in the Philippine Banking System

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The Philippine commercial banking system, which dominates the banking system, represents the largest single group, resource-wise, of financial institutions in the country and carries the greatest number of functions as well as the highest minimum capital requirements. The improvement in the economy and

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the liberalization of bank entry and branching in the 1990s paved the way for the increase in the number of commercial banking institutions. However, due to structural changes and competition, a continuous decline in the number of commercial banks since 1997 has been observed, as mergers and acquisitions

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have increased. But still, the number of bank branches has remained almost the same at more than 4000.

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As of December 2011, there were 38 operating commercial banks in the country, down from 44 in 2001. The number of foreign commercial banks was14, up from four before the liberalization in 1994.

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Since the early 1980s, major reforms in the Philippine financial system have been introduced by the government to improve its efficiency, not only in carrying out its tasks as intermediaries in the financial market but also to make it financially strong enough to withstand adverse shocks.4 For example, after the East Asian financial crisis in 1997, the country‟s central bank, the Bangko Sentral ng Pilipinas (BSP) implemented more reforms to improve the capacity of the banking system to face the adverse shocks of the crisis, as well as to support the system‟s institutional structure in dealing with problem banks. The key reforms were focused on risk management, stronger capital base, and improved corporate governance standards in the banking system. At the same time, the Philippines has substantially implemented reforms on its commercial banking system to keep up with the “best-practice” banking regulations recommended by the BCBS and to keep up with the international banking standards. For example, the BSP has implemented Basel I in July 2001, covering credit risk only; and in July 2003, incorporating market risk.

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See Manlagnit (2011) for the discussion on the earlier major reforms in the Philippine commercial banking system.

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The adoption of the Basel II framework in the country for all universal and commercial banks and their subsidiary banks and quasi-banks on both solo and consolidated bases started in 2007. Specifically, the first (minimum capital requirements) and third (market discipline) pillars took effect in July 2007 while the second pillar (official supervisory power) took effect in January 2011 and was made applicable

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to universal and commercial banks at a consolidated level only. For the implementation of the said Accord, the BSP has prepared the local banks by gradually changing its regulatory framework, enhancing corporate governance in banks, capacity building, and

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supporting the establishment of critical market infrastructures, among others. Specifically, the BSP has issued a series of guidelines in strengthening BSP‟s compliance with the Basel Core Principles for

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Effective Banking Supervision, as well as with the international standards for corporate governance; supported the development of the domestic credit ratings industry through the issuance of the recognition

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and derecognition guidelines for credit rating agencies; and pushed legislative changes to its charter to include provisions necessary for the effective implementation of Basel II (BSP 2004). The international standards under Basel requirements require that the capital adequacy ratio

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(CAR) for banks must not be lower than 8%. To better address potential systemic risks, the CAR requirement in the country is more strict set by the BSP at 10%. As of end-December 2011, the CAR of the banking system was at 17%, significantly higher than the 10% statutory standard and certainly well

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above the international benchmark of 8%. Commercial banks have remained well-capitalized at levels

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above both the BSP-regulatory requirement and the Basel Accord standard. Moreover, with the implementation of Basel II, the banks are not only forced to reduce their risk assets but also compelled to

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consider alternative strategies in fortifying capital and meet the requirements set by the BSP. It is noteworthy that according to the surveys conducted by the World Bank, the country has the highest increase in restrictions on bank capital from 1999 to 2006 (see Barth, Caprio and Levine 2012). Since banks are well-capitalized, the country‟s commercial banking system adopted the capital adequacy standards under Basel III in January 2014, four years earlier than the full timeline given by BCBS. Since the new framework will significantly increase the quality and required level of banks‟ capital, it is expected to strengthen banks‟ capacity to absorb risks and reduce the probability of future banking crises. Although Basel III covers new rules for both capital and liquidity in the banking sector, the BSP implementation plan so far does not cover the liquidity standards of Basel III. A preliminary study by Parcon-Santos and Bernabe (2012) on the macroeconomic effects of the implementation of Basel III in the country shows that the higher capital requirements imposed by the new framework may have an initial negative impact on the country‟s economy but the estimated net effect of the implementation is positive but modest.

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Theoretical model for estimation of cost efficiency This paper uses the stochastic cost frontier analysis independently proposed by Aigner, Lovell

and Schmidt (1977) and Meeusen and van der Broeck (1977), which is a means to measure the relative performance of banks by objectively providing numerical efficiency values and ranking these

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accordingly. Under this methodology, a commercial bank is considered inefficient if its costs are higher than those predicted for an efficient commercial bank producing the same output under the same existing conditions with the difference unexplainable by statistical noise. In this way, it shows how close banks are

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to the „„best-practice‟‟ frontier. Specifically, a stochastic cost function model implies that a bank‟s observed total cost will deviate from the cost-efficient frontier, i.e., minimum or best-practice cost

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frontier, because of random noise and possible firm inefficiency. For panel data, the cost function can be written as

(1)

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ln TCit  ln TC ( yit , wit ;  )   it

where TCit is the observed total cost of production at the t-th year (t = 1, 2,…, T) for the i-th bank (i =

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1,2,…,N);5 y it is the vector of banking output; wit is the vector of input prices; and  is a vector of unknown coefficients for the associated output and input price variables in the cost function. Thus,

ln TC( yit , wit ;  ) is the predicted log cost function of a cost minimizing bank operating at ( yit , wit ).

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which can be written as

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Following Aigner, Lovell and Schmidt (1977),  it is the error term of the cost function for the i-th bank

(2)

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 it  vit  uit

where vit represents errors of approximation and other sources of statistical noise assumed to be independent and identically distributed as N (0,  v2 ) and u it is a random variable which is assumed to be an independently but not identically distributed non-negative random variable.

4.1

Data and definition of variables This study uses data from the balance sheets and income statements of individual domestic

commercial banks obtained from the Philippine Securities and Exchange Commission (SEC) for the period 2001 to 2011. The panel data, which consist of 186 observations, include 17 commercial banks whose assets accounted for 70% and 80%, on average, of the total assets of the whole commercial banking system and the domestic banking system, respectively. These 17 domestic banks, which meet the minimum requirements of having a complete data set that covers at least seven years, are comprised of 10 5

It is not necessary that all banks are observed for all T periods although it is assumed that there are T time periods for which observations are available.

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universal banks and 7 commercial banks. Meanwhile, data for the regulatory and supervisory variables are obtained from Barth, Caprio and Levine (2001, 2004 and 2006) World Bank (WB) database. Although there is no consensus on the explicit definition and measurement of banks‟ inputs and outputs, this study uses the intermediation approach proposed by Sealey and Lindley (1977). According

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to this approach, banks as financial intermediaries use labor, capital, deposits, and other borrowed funds to produce earning assets. This approach considers banks as collectors of funds, which are then intermediated into loans and other assets. Because this approach takes into account the overall costs of

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banking, i.e., both operating and interest costs, it is the more suitable approach in dealing with concerns regarding the economic viability of banks, as in this study.

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The dependent variable is the total costs, lnTC, which are the sum of operating and financial expenses. Three output quantities are included: total loans (Y1), securities (Y2), and contingent accounts

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(Y3).6 The three input prices include wage rate (W1) measured by the ratio of personnel expenses to total assets, as data on the number of employees are not available; price of physical capital (W2), defined as the ratio of occupancy expenses to the book value of fixed assets; and price of funds (W 3), measured as the normalize total costs and the other input prices.

Potential correlates of inefficiency

4.2.1

Bank regulation and supervision

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4.2

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ratio of total interest expenses to total funds. In imposing linear homogeneity, the price of funds is used to

To examine the impact of Basel II on the efficiency of the banks, the three pillars are included in

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the estimation: (1) capital regulation; (2) official supervisory power; and (3) private monitoring. The proxies for regulation and supervision variables are constructed following Barth, Caprio and Levine (2004, 2006).7

The bank capital regulation index, which is the proxy for pillar 1, includes both initial and overall capital stringency. Initial capital stringency measures the extent of regulatory requirements regarding the amount of capital that banks must have relative to specific guidelines while overall capital stringency measures the extent to which the source of funds that count as regulatory capital can include assets other than cash or government securities, borrowed funds, and whether the sources of capital are verified by the regulatory or supervisory authorities. Therefore, the index captures both the amount of capital and 6

Aside from the including traditionally defined outputs, this paper includes contingent accounts as output variable, which serves as a proxy for other services offered by banks. The contingent account of banks, although considered as technically non-earning assets of the banks, is becoming a growing source of income for banks and thus, if excluded, total output would tend to be understated (Jagtiani and Khanthavit 1996). In a Philippine study, Lamberte (1982) included contingent accounts as one of the inputs in a multi-product joint cost function of banks and found a monotonically declining marginal cost curve for this variable, indicating possible cost advantages by banks from expanding the volume of their output. 7 See Appendix for details on calculation of the variables. See also Barth, Caprio and Levine (2006) for information on the data, sources, and specific survey questions used to construct the variables for this paper.

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verifiable sources of capital that a bank required to possess. It is calculated on the basis of 9 questions and ranges in value from 0 to 9, with a higher value indicating greater stringency. The official supervisory power index, which is a proxy for pillar 2, measures the extent to which official supervisory authorities have the authority to take specific actions to prevent and correct problems.

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It is calculated based on 14 questions indicating the extent to which supervisors can change the internal organizational structure of the bank and/or take specific disciplinary action against bank management and directors, shareholders, and bank auditors.

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The market discipline index, which is a proxy for pillar 3, measures the degree to which private sector monitoring of banks influences bank performance and fragility. It takes the value between 0 and 8

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with higher values indicating higher disclosure requirements and more incentives to increase private monitoring.

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Theory provides explanations to different approaches to bank supervision.8 The official supervision approach states that official supervisors have the capabilities to avoid market failure by directly overseeing, regulating, and disciplining banks. However, Barth, Caprio and Levine (2006)

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mention that having powerful government regulators and supervisors may also result to corruption and impede bank operation and thus, will not improve bank performance and stability. Specifically, the authors‟ empirical results show that there is no strong association between bank development and

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performance and official supervisory power. In a related study, Barth, Caprio and Levine (2003),

political systems.

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however, show that official government power is harmful to bank development in countries with closed

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On the other hand, the private monitoring approach states that powerful supervision might be related to corruption or other factors that impede bank operations, and regulations that promote private monitoring will result in better outcomes for the banking sector. In practice, private monitoring of banks has been greatly encouraged by many supervisory agencies, e.g., acquiring certified audits and/or ratings from international-rating agencies; making bank directors legally liable if information is erroneous or misleading; requiring banks to produce accurate, comprehensive and consolidated information on the full range of bank activities and risk-management procedures; and imposing a “no deposit insurance” policy by some countries (Barth, Caprio and Levine 2004). However, in countries with poorly-developed capital markets, accounting standards, and legal systems, there is still great reservation in placing excessive trust in private-sector monitoring. It is argued that such countries will benefit more from official supervisors and regulators where banks have excessive risk-taking behavior and therefore, encouraging more confidence in depositors than from private-sector monitoring. With weak institutional settings, increased

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For detailed discussions of these two approaches, see Barth, Caprio and Levine (2004) and Levine (2005).

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dependence on private monitoring may lead to exploitation of small savers and thereby much less bank development. Several studies find that pillar 2 and pillar 3, although not necessarily mutually exclusive, reinforce each other; that is, countries could adopt regulations that enhance both the disclosure of accurate

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information and the creation of powerful supervisors (see Levine 2005). For example, Beck, DemirgucKunt and Levine (2006) argue that when market discipline is enhanced, the corruption of bank officials will be less of a constraint on corporate finance. Moreover, Fernandez and Gonzalez (2005) argue that a

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greater quality of information provided by a system that enhances private monitoring through accounting and auditing requirements might improve the supervisors‟ abilities to intervene in managerial decisions in

Risk and asset quality

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4.2.2

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the right way and at the right time.

To control for risk and asset quality of the commercial banks, financial capital and loan losses are incorporated in the estimation. The ratio of provisions for loan losses to total loans is used following

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Mester (1996) and Altunbas et. al (2000) to control for asset quality. In this study, it is hypothesized that an inefficient bank with high costs would have more problem loans, so that loan loss provisioning would

DeYoung 1997; Rao 2005).

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be positively related to higher operating costs indicating lower cost efficient operations (Berger and

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Meanwhile, the ratio of financial capital to total assets is included in the estimated cost function to take into account the differences in risk preferences of banks, as suggested by Hughes and Mester

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(1993) and Mester (1996). Since the level of financial capital is fundamentally linked to the bank‟s risk management and risk signaling, it is hypothesized that to the extent that well-capitalized banks reflect high quality management, these banks are more likely to be more cost efficient in producing bank outputs by their cautious risk taking behavior (Rao 2005).

4.2.3

Bank-specific variables and other variable The potential correlates that controls for bank-specific features include: (1) intermediation ratio

defined as the proportion of loans to deposits, which captures the differences among domestic banks‟ ability to convert deposits into loans and reflects the developments in the legal and regulatory frameworks that support both the financial intermediation process and lower costs to banks; (2) deposit-to-liability ratio represents the governance stance of the bank, which is based on Jensen‟s (1989) free cash flow theory that states that an appropriate policy to control agency costs is to limit free cash flows available in order to constrain the expense preference behavior of managers by having an adequate level of debt and strong control from the institution‟s owners; and (3) a dummy variable for commercial bank type, which 11 Page 12 of 29

takes the value of one for universal commercial banks and zero for ordinary commercial banks. Bank type and size may positively influence efficiency levels as big banks with different functions and scope may have greater portfolio and loan diversification and gain from size advantages (Hughes, Mester and Moon 2001; Yildirim and Philippatos 2007; Altunbas et al. 2007).

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In addition, a variable for the degree of asset market concentration defined as the ratio of assets of the three largest banks to the total assets of commercial banks, which reflects either higher or lower costs for the banks, e.g., if market concentration manifests as market power for some banks, it may lead to an

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increase in costs for the sector in general through inefficiency; if, on the other hand, it manifests as market selection and consolidation through survival of more efficient banks, market concentration may be

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suggestive of lower costs. Table 1 provides the summary of the definitions of the variables included in

4.3

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the model along with their descriptive statistics.

Model specification

To calculate the efficiency of each individual bank in the sample, a translog cost function is used.

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This functional form is popular among researchers because it allows some flexibility when estimating the frontier function. Given the variables defined above, the cost function, is specified as

1 2

3

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  k

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w

 qt 



3

3

 y jit   y 

    k ln kit     jl ln   lit   j ln  w  2   q  ln q  q  3it  j1 j l  it  k 1  it   it  kp

1 rt 2  2

3

 j

1

 y jit   wkit   w pit  1 3 3      ln  ln jk    q  ln w it   w3it  2 j k    3it 3  y jit  w  t   jt ln  kt ln kit t  u it  vit   w3it  k  q it 

w ln kit  w3it



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

 y jit 

3

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    0  

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 TC it ln   q it w3it

  

(3)



where ln TCit is the natural logarithm of total costs of the i-th bank in time t; ln yit the natural logarithm of the j-th output; ln wkit the natural logarithm of the k-th input price; t is the year of observation which is a proxy to capture any changes that may have occurred during the period included in the study which are not explicitly controlled for in the model; qit is the total assets9; and  are the coefficients to be

9

Following Berger and Mester (1997), Hardy and di Patti (2001) and Fu and Heffernan (2007), the cost and output terms are expressed as a ratio of total assets, q to mitigate size-related heteroscedasticity and any potential bias arising from differences in scale.

12 Page 13 of 29

Table 1. Descriptive statistics of the variables

10,576

79,688

94,028

102,277

109,207

101,634

187,609

0.01

0.00

0.29

0.20

0.28

0.19

5.54

1.24

11.63

0.48

6.00

0.00

0.05

0.02

0.13

0.04

0.59

0.21

0.88

0.61

0.59

0.49

0.39

0.05

an

M

d

te

10,646

us

Dependent variable Total costs: financial expenses and TC operating expenses (Php millions) Independent variables Variable output quantities Y1 Total loans (Php millions) Securities: total assets less total loans Y2 and fixed capital (Php millions) Y3 Contingent accounts (Php millions) Variable input prices Wage rate: ratio of personnel W1 expenses to total assets Price of physical capital: ratio of W2 occupancy expenses to fixed assets Price of funds: ratio of total interest W3 expenses to total funds Potential correlates Bank regulation and supervision variables Capital includes both initial and overall requirement capital stringency measures the extent to which official Official supervisory authorities have the supervisory authority to take specific actions to power prevent and correct problems measures the degree to which private Private sector monitoring of banks influences monitoring bank performance and fragility Risk and asset quality variables LLP/Total Ratio of loan loss provisions to total loans loans Equity/Total Ratio of financial capital to total assets assets Bank-specific variables/Other variable Intermediation Ratio of loans to deposits Deposit Ratio of deposit to total liabilities liabilities Dummy for commercial bank type: Bank type 1=universal bank; 0=ordinary bank Ratio of assets of 3 largest Bank commercial banks to total assets of concentration commercial banks

Ac ce p

Standard deviation

Mean

ip t

Description

cr

Variables

Sources of basic data: Philippine Securities and Exchange Commission, World Bank Banking Regulation Surveys

13 Page 14 of 29

estimated. In accordance with economic theory, costs and input prices in equation (3) are normalized using one of the variable input prices ( w3it ) to impose linear input price homogeneity. This study employs the Battese and Coelli (1995) model, which allows the simultaneous estimation of the stochastic cost function and the identification of the correlates of bank inefficiencies in

ip t

one-step estimation,10 to incorporate the regulation and supervisory variables and examine the correlates of efficiency. This approach assumes that environmental factors directly affect technical efficiency of the banks, that all banks share the same technology represented by the production frontier, and that the

cr

environmental factors have an influence only on the distance that separates each bank from the best

Under this one-step approach, the uit is defined as uit  zit  wit

us

practice function (Coelli, Perelman and Romano 1999).

(4)

an

where uit follows a truncated-normal distribution with mean zit and variance  u2 ; zit is a vector of explanatory variables, i.e., risk and quality variables and bank-specific variables that may influence the

M

efficiency of the banks;  is a vector of parameters to be estimated; and wit is defined by the truncation of the normal distribution N (0,  2 ) , such that the point of truncation is  zit , i.e., Wit   z it  . It is to note that the frontier model (equations 3 and 4) accounts for both technical change and

d

time-varying inefficiency effects. To account for non-neutral technical change, the stochastic frontier

te

(equation 3) has the time trend, t, interacted with the input variables while a time-squared variable was included to allow for non-monotonic technical change (Coelli, Rao and Battese 2005). The overall cost

Ac ce p

efficiency of production for the i-th bank at the t-th year of observations is the ratio of the stochastic frontier input cost used to the observed input used. The stochastic frontier input cost use is defined by the value of input cost use if the cost inefficiency effect, uit , was zero, i.e., the bank was fully efficient in the use of input. Given the specifications of the translog stochastic frontier cost function in equations (3) and (4), the cost efficiency of a bank can be expressed as CEit  exp( uit )

(5)

10

This is in contrast to the two-step estimation approach (see Pitt and Lee 1981), in which the first step involves the specification and estimation of the stochastic frontier production function and the prediction of the technical inefficiency effects; while the second step involves the specification of the regression model for the predicted technical inefficiency effects. But such an approach may be inconsistent in its assumptions regarding the independence of the inefficiency effects in the two estimation stages (Coelli 1996). See also Wang and Schmidt (2002) for further discussion on the merit of the one-step, simultaneous estimation.

14 Page 15 of 29

which indicates that the cost efficiency is no greater than one. The prediction of the cost inefficiencies is based on conditional expectations which generalize the estimators computed in Jondrow et al. (1982) and Battese and Coelli (1988, 1993).11 Equation (3) and equation (4) are estimated simultaneously using the Maximum Likelihood (ML)

ip t

approach using the computer program, Frontier Version 4.1 by Coelli (1996). The program estimates the parameters of the model using the parameterization of Battese and Corra (1977) with  2  ( v2   u2 ) and

Empirical results

5.1

Tests of hypothesis

us

5

cr

   u2 /( v2   u2 ).

The results using the generalized likelihood-ratio (LR) tests in evaluating hypotheses for the

an

sufficiency of representation of the cost structure of the banks in the sample are shown in Table 2. The first null hypothesis (H0:  = 0), which states that the technical inefficiency effects have a half-normal

M

distribution, is strongly rejected. The second null hypothesis (H0: = 0), which specifies that the inefficiency effects are absent from the model, is strongly rejected, suggesting that the inefficiency component needs to be incorporated in the model and that an average cost function is not an adequate

d

representation of the data. The third hypothesis (H0: 1 = … = 9 = 0) specifies that the inefficiency

te

effects are not a linear function of the bank and regulation, risk and asset quality, and other bank-specific variables, and therefore have no significant impact on the cost structure of the commercial banks. This

Ac ce p

hypothesis is strongly rejected, indicating that these variables are useful in describing the cost inefficiencies of the banks. The last hypothesis specifies that the interaction term of no technical change (H0: 3 = i3 = 0, i=1; 2; 3) is rejected, indicating that technological change exists in the commercial banking sector. Given the specifications of the translog stochastic cost frontier function model, the results from the tests of hypotheses suggest that a simpler model like ordinary least squares (OLS) cannot adequately specify the cost inefficiency of commercial banks in the country.

5.2

Properties of cost inefficiency

The overall mean cost efficiency estimate for the period 2001‒ 2011 is 0.75. This result indicates that, on average, 25% of the commercial banks‟ costs are wasted relative to the best-practice commercial bank within the sample producing the same output and facing the same conditions. The cross-sectional distribution of cost efficiency estimates of the commercial banks, which provides rankings of the banks, It is to note that ( ' zit  wit )  ( ' zi't  wi't ) for i  i' does not necessarily imply that ( ' zit'  wit' )  ( ' zi't '  wi't ' ) for t  t '. It follows then that the same ordering of banks in terms of cost inefficiency of production does not apply to all time periods. 11

15 Page 16 of 29

suggests that the most efficient bank in the sample could still be operating with a moderate level of inefficiency.

Table 2. Tests of hypothesis

Test for half-normal functional form: H0:  = 0 Test of no inefficiency effects: H0: = 0 Test of potential correlates: H0: 1 = … = 9 = 0 Test of no technical change over time: H0: 3 = i3 = 0, i=1,2,3

46.42 177.59 32.87 21.12

*

Critical Value* 23.21 20.97** 11.34 13.28

Decision

ip t

LR

cr

Null hypothesis

Reject H0 Reject H0 Reject H0 Reject H0

All are statistically significant at the 1% level. Obtained from Table 1 of Kodde and Palm (1986) because γ=0 is on the boundary of the parameter space and the asymptotic distribution of the generalized likelihood ration statistic is a mixed Chi-square distribution. Source: Author‟s calculation

us

**

an

Figure 1 presents the average measured cost efficiency of all commercial banks from 2001 to 2011. The early 2000s is characterized by an improving cost efficiency, followed by a slight drop in efficiency in 2005 which could be attributed to regulatory tightening such as the phased-in

M

implementation of the modified local capital adequacy framework in preparation for the full implementation of Basel II in 2007; adoption of new accounting and financial reporting standards; and

d

preparation for internal rating-based approach for full implementation in 2010 (BSP 2005). In addition,

cleanup (BSP 2005).

te

the system is still saddled with a continuing overhang of bad assets and the costs associated with asset

After 2005, an improvement in the cost efficiency of the banks can be observed. Several factors

Ac ce p

can explain this improvement in the efficiency of the banks. For one, the asset quality of the banking system has remarkably improved. With the implementation of Basel II in July 2007, banks‟ capital became more risk-sensitive in line with international standards and remained well above the minimum BSP regulatory requirement of 10% and the international benchmark of 8%. Even with the onset of the global financial crisis in 2008, the banks efficiency remained cost efficient partly because of the earlier reforms implemented by the BSP particularly on overall risk management of banks and the much-needed cushion provided by banks‟ sustained profitability in the past. As Kawai (2009) and Guinigundo (2009) have pointed out, the overall performance of the banking system in the Asian region reflects the improvements in risk management since the Asian crisis of 1997‒ 98 and the lessons learned from that crisis have served the region well in the global financial crisis. However, starting in 2009, a decline in efficiency can be observed, which could be attributed to the global financial crisis. Although the direct damage of the global financial crisis to the financial sector in Asia, in general, and the Philippines, in particular, has been much less than in the US and Europe, such

16 Page 17 of 29

Figure 1. Cost efficiency estimates, 2001–2011 0.90

0.84 0.80 0.80 0.77 0.76

0.75

0.74 0.71

0.71

us

0.70 0.69

an

0.65

0.60 2001

2002

2003

2004

2005

2006

2007

2008

2009

0.71

2010

2011

M

Source: Author‟s calculation

0.77

cr

0.75

ip t

0.85

a result suggests that external shocks can affect the commercial banks‟ measured efficiencies. As a result,

d

the operating costs of the banks may have increased in compliance with more stringent structural reforms

te

and policies imposed by the monetary authorities to strengthen the banking system in the aftermath of the global crisis. For example, the BSP issued new rules and regulations that address the assessment of

Ac ce p

banks‟ risk exposures to US and European bank debts as well as strengthening the banks‟ capital needs as a buffer to any adverse shocks to the stability of the banking system. Also, in 2011, the BSP implemented certain provisions of Basel III for determining capital instruments that can be counted as regulatory capital by Philippine banks from January 2011 onwards. Moreover, the costs can be attributed to higher funding costs due to the volatility in the global credit markets. In a report by the Institute of International Finance in October 2009 (Guinigundo 2009), new regulations requiring banks to hold high-risk-based levels of capital were expected to prod international banks to retrench from emerging market lending. In general, all these costs are likely to be positively related to the operating expenses of the commercial banks. Overall, the performance of the banks suggests the regulatory changes continuously implemented by the government to strengthen the banks and lessen the impact of the external shocks to the economy. It is expected that implementing regulations is likely to increase operational costs and thus, decrease banks‟ cost efficiency. It is to note, however, that this decrease in efficiency that started in 2009 is lower than the early 2000s level where banks were struggling with higher bad loans. 17 Page 18 of 29

5.3

Potential correlates of cost efficiency Table 3 shows the results from the maximum likelihood estimation that relate the measures of

cost inefficiency to potential correlates.12 In the absence of a theoretical rationale for determinants of the efficiency of the banks, these correlates, which are at least partially exogenous, are generally considered

Std error 0.0651 0.1489 0.2954

M

an

us

Table 3. Correlates of Cost Inefficiency Variable Coefficient Bank regulation and supervision Capital requirement -0.1445** Official supervisory power 0.3348** Market discipline -0.4461 Risk and asset quality Loan loss provision 2.3583** Financial capital -0.0553** Bank-specific/Other Intermediation ratio 0.4552*** Deposit liabilities -0.0741** Bank type -0.1297* Bank concentration 0.6860***

cr

they should be interpreted with caution.13

ip t

in the current literature as potential sources of inefficiency among banks. While the results are suggestive,

0.9377 0.0317 0.0961 0.0289 0.0685 0.2622

Bank regulation and supervision

te

5.3.1

d

***, **, and * statistically significant at the 1%, 5%, and 10% levels, respectively. Source: Author‟s calculation

The first pillar of Basel II, capital requirement, has a significant negative effect on measured cost

Ac ce p

inefficiency, indicating that an increase in capital requirements of banks tends to improve their cost efficiency. This finding, which is consistent with the study of Thangavelu and Findlay (2011) on Southeast Asian banks, suggests that banks might experience better risk management if they assume greater ownership of their activities, which is in line with the recent recommendation by the Basel II Accord to increase capital requirements to manage the risk-taking activities of banks (BIS 2006). Moreover, as explained by Berger and Bonaccorsi di Patti (2006), higher capital requirements could lead to higher levels of equity capital that could lower the probability of financial distress, which decreases the need for costly risk management activities. Supervisory power, the second pillar or Basel II, is statistically significant and positively correlated with bank‟s cost inefficiency, suggesting that more powerful supervisors can adversely affect the efficiency of the banks. Consistent with the previous studies of Barth, Caprio and Levine (2002, 2004,

12

It is to note that the quantity actually computed in Frontier 4.1 is the reciprocal of equation (5) and can be interpreted as a measure of the cost inefficiency of individual banks. 13 As Mester (1996, 1997) suggested, the results simply provide information on the correlation between inefficiency and various indicators included in the study. Moreover, due to possible endogeneity, the relationship need not imply causality.

18 Page 19 of 29

2008 and 2012) and Caprio, Leaven and Levine (2007), this result suggests that empowering direct official supervision does not improve bank efficiency. In this respect, this finding supports the private interest approach to bank regulation and supervision (see Barth, Caprio and Levine 2006) that argues that governments with powerful supervisors may use this power to benefit favored constituents or their own

ip t

private welfare, which in turn results in inefficient banking institutions and overcoming market failures. It is to note, however, that a follow-up study should be conducted in evaluating the effect of supervisory power since the coverage of this study with respect to this pillar is very limited.14

cr

The third pillar, market discipline, is negatively correlated to cost inefficiency but statistically insignificant in explaining the inefficiency of the banks. This finding suggests that there is still a need to

us

strengthen and enhance corporate governance and private sector monitoring of the financial markets in the country to reduce corruption and ambiguity in bank lending and improve the functioning of the banks as

an

true financial intermediaries. As noted by Thangavelu and Findlay (2010), the more developed and welldiversified financial markets will rely heavily on the private sector to provide information on the activities of the banks for depositors and potential investors; however, given the stage of growth of the financial

M

markets in Southeast Asia and developing countries, private monitoring might not produce a positive impact in these countries as compared to those hosting well-developed financial markets. Interestingly, as in the case of the Philippines, Barth, Caprio and Levine (2012) noted from the series of surveys that

d

many more countries were increasing capital requirements from 1999 to 2009, whereas there is no marked

te

difference in the increase or decrease of supervisory powers and slightly fewer countries increasing

5.3.2

Ac ce p

private monitoring compared with those decreasing it.

Risk and asset quality

Loan loss provision is statistically significant and is consistent with a priori expectations that it is positively correlated with bank‟s inefficiency (Altunbas et al. 2000; Berger and DeYoung 1997; Girardone, Molyneux and Gardener 2004). An inefficient bank with high costs would have more problem loans so that loan loss provisioning, as a proxy for loan quality, would be positively related to higher operating costs.

Financial capital, which captures capital risk and the risk preference of a bank‟s management, has a significant negative effect on measured cost inefficiency. Consistent with the findings of Mester (1996) and Girardone, Molyneux and Gardener (2004), this suggest that to the extent that well-capitalized banks reflect high quality and better risk management, these banks are likely to be more cost efficient in producing banking outputs.

14

Pillar 2 took effect only in January 2011 and this study covers 2001–2011.

19 Page 20 of 29

5.3.3

Bank-specific characteristics/Other variable For bank-specific characteristics, the intermediation ratio has a significant and positive effect on

measured cost inefficiency, indicating that a higher ratio increases the costs of the banks. This suggests that the financial intermediation process among domestic banks is still costly and inefficient. The deposit

ip t

to liabilities ratio has a significant and negative effect on measured cost inefficiency, suggesting that a higher ratio curtails the expense preference of bank managers. Among commercial banks, the results seem to indicate that universal commercial banks are more cost efficient than ordinary commercial banks,

cr

suggesting that universal commercial banks are able to have greater portfolio and loan diversification and gain from size advantages. For the additional variable used, bank concentration is positive and statistically

us

significant, suggesting that market concentration manifests as market power for some banks, thus leading

5.4

an

to an increase in costs for the sector in general through inefficiency.

Robustness check

To check the robustness of the results, this study follows Bauer et al. (1998), who argue that, in

M

order to make sure that the frontier measures are not simply artificial products of assumptions made regarding underlying optimization concepts and frontier methodology, efficiency measures should be correlated (with the expected signs) with nonfrontier measures of performance generally used by

d

regulators and financial institutions managers.

te

The raw measure of cost efficiency includes the ratio of total costs to total assets of banks (Cost/TA) while the measures of profitability include return on assets (ROA), return on equity (ROE),

Ac ce p

and ratio of net interest income to average interest earning assets (NII). It is expected that the bank cost inefficiency levels would be positively correlated with the cost ratio and negatively correlated with profitability measures. The results show that that these efficiencies are significant in the expected way with the standard, nonfrontier measures of performance (Table 4).

Table 4. Correlation between cost inefficiency and standard accounting ratios Cost Variable Cost/TA ROA ROE NII Inefficiency Cost inefficiency 1.00 Cost/TA 0.83*** 1.00 ROA -0.68*** -0.56* 1.00 ROE -0.97*** -0.56* 0.98*** 1.0 NII -0.57* -0.60* 0.31 0.43 1.00

*** and * statistically significant at the 1% and 10% levels, respectively. Source: Author‟s calculation

20 Page 21 of 29

6

Conclusion and policy implications Although many countries have followed the Basel guidelines, existing evidence on the positive

impact of Basel II on bank efficiency is at best mixed. Given that the banking supervisors in the Philippines strongly advocate the implementation of Basel guidelines and yet, existing studies is still

ip t

relatively scarce, focusing on this concern is long overdue. Thus, this paper attempts to fill the gap in banking regulations and bank performance studies as it focuses on the analysis on Basel II and bank efficiency from a developing country perspective. Using stochastic frontier analysis, this paper has

cr

examined the impact of Basel II on the cost efficiency of Philippine commercial banks from 2001 to 2011. The empirical findings show that the overall mean cost efficiency estimate is 0.75, indicating

us

substantial inefficiencies in the banks averaging to 25% of total costs.

Findings show that higher capital requirement tends to improve the cost efficiency but more

an

powerful supervisors can adversely affect the efficiency of the banks. However, market discipline is not significant in explaining bank efficiency. On capital requirements, the finding suggests that banks might experience better risk management if they assume greater ownership of their activities, which is in line

M

with the recent recommendation by the Basel II Accord to increase capital requirements to manage the risk-taking activities of banks. On supervisory powers, the finding supports the private interest approach to bank regulation and supervision (see Barth, Caprio and Levine 2006) that argues that governments with

d

powerful supervisors may use this power to benefit favored constituents or their own private welfare,

te

which in turn results in inefficient banking institutions and overcoming market failures. Lastly, since market discipline is not significant suggests that there is still a need to strengthen and enhance corporate

Ac ce p

governance and private sector monitoring of the financial markets in the country to reduce corruption and ambiguity in bank lending and improve the functioning of the banks as true financial intermediaries. The other potential correlates that may help explain the cost efficiency of the banks are loan loss provision and financial capital, suggesting that higher cost efficiency is expected to be correlated with better credit risk evaluation and banks with less risky assets and well-capitalized banks are performing better. In addition, cost inefficiency seems to be strongly related to intermediation ratio and deposit liabilities ratio. Among commercial banks, the results seem to indicate that universal commercial banks are more cost efficient than ordinary commercial banks. From a policy perspective, this study is informative to policymakers on the general direction in which to proceed with reforms (i.e., maintain higher capital requirements, curtail powerful supervisors, and enhance private monitoring) to improve and strengthen the country‟s commercial banks as well as in identifying factors that could contribute to their efficiency. In light of the implementation of Basel III regulations in the country, it is imperative to know whether the Basel regulations have positive impact on

21 Page 22 of 29

the efficiency of commercial banks. In effect, this paper also assesses the readiness of the commercial

Ac ce p

te

d

M

an

us

cr

ip t

banks towards the implementation of Basel III in the country.

22 Page 23 of 29

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ip t

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cr

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Appendix Description This variable takes values between 0 and 9, with higher values indicating grater stringency. It is determined by adding 1 if the answer is yes to questions 1-7 and 0 otherwise, while the opposite occurs in the case of questions 8 and 9 (i.e. yes=0, no =1). (1) Is the minimum required capital asset ratio risk-weighted in line with Basle guidelines? (2) Does the ratio vary with individual bank‟s credit risk? (3) Does the ratio vary with market risk? (4-6) Before minimum capital adequacy is determined, which of the following are deducted from the book value of capital: (a) market value of loan losses not realized in accounting books? (b) unrealized losses in securities portfolios? (c) unrealized foreign exchange losses? (7) Are the sources of funds to be used as capital verified by the regulatory/supervisory authorities? (8) Can the initial or subsequent injections of capital be done with assets other than cash or government securities? (9) Can initial disbursement of capital be done with borrowed funds? This variable takes values between 0 and 14, with higher values indicating higher power of the supervisory authorities. It is determined by adding 1 if the answer is yes and 0 otherwise, for each one of the following 14 questions: (1) Can supervisors meet external auditors to discuss report without bank approval? (2) Are auditors legally required to report misconduct by managers/directors to supervisory agency? (3) Can legal action against external auditors be taken by supervisor for negligence? (4) Can supervisors force banks to change internal organizational structure? (5) Are off-balance sheet items disclosed to supervisors? (6) Can the supervisory agency order directors/management to constitute provisions to cover actual/potential losses? (7) Can the supervisory agency suspend director's decision to distribute: dividends? (8) bonuses? (9) management fees? (10) Can the supervisory agency supercede bank shareholder rights and declare bank insolvent? (11) Does banking law allow supervisory agency to suspend some or all ownership rights of a problem bank? (12) Regarding bank restructuring & reorganization, can supervisory agency or any other govt. agency do the following: supercede shareholder rights? (13) remove and replace management? (14) remove and replace directors?

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Official supervisory power

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Variable Capital requirement

This variable takes values between 0 and 8, with higher values indicating policies that promote private monitoring. It is determined by adding 1 if the answer is yes and 0 otherwise, for each one of the following 8 questions: (1) Is subordinated debt allowable (required) as part of capital? (2) Are consolidated accounts covering bank and any non-bank financial subsidiaries required? (3) Are off-balance sheet items disclosed to public? (4) Must banks disclose risk management procedures to public? (5) Are directors legally liable for erroneous/misleading information? (6) Do regulations require credit ratings for commercial banks? (7) Does income statement contain accrued but unpaid interest/principal while loan is non-performing? (8) Is there an explicit deposit insurance scheme? Source: Barth, Caprio and Levine (2004, 2006)

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Private monitoring

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