Helping hand or grabbing hand?

North American Journal of Economics and Finance 19 (2008) 153–173

Contents lists available at ScienceDirect

North American Journal of Economics and Finance

Helping hand or grabbing hand? Politicians, supervision regime, financial structure and market view夽 Donato Masciandaro a,∗, Marc Quintyn b a b

Bocconi University, Italy International Monetary Fund, United States

a r t i c l e

i n f o

Article history: Received 2 August 2007 Received in revised form 23 December 2007 Accepted 11 February 2008 Available online 18 March 2008 JEL classification: G18 G28 E58 Keywords: Financial supervision Political economy Grabbing hand Banking concentration Market view

a b s t r a c t Almost all the literature on the evolution of the financial supervision architecture stresses the importance of financial market characteristics in determining the recent trend toward more unification. But in the real world it is not always clear to what extent market features matter. We present two complementary approaches to gain insights in the above relationship, focusing on the political cost and benefit analysis. First, a cross-country study tests two alternative theories—the helping hand and the grabbing hand view of government—to determine the impact of the market structure on the supervisory setting. Our evidence seems more consistent with the grabbing hand view, considering the degree of banking concentration a proxy of the capture risk and presuming the market demonstrates a preference for consolidation of supervisory powers. Second, the results of a survey among financial CEOs in Italy confirm a market preference for a more consolidated supervisory regime but reveal only weak consistency between the views of the policymakers and those of the market operators. © 2008 Elsevier Inc. All rights reserved.

1. Introduction In recent years many countries have made drastic changes to the architecture of financial supervision, and more countries are contemplating modifications. The current restructuring wave is making

夽 The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. ∗ Corresponding author. Tel.: +39 02 58365310; fax: +39 02 58365343.

E-mail address: [email protected] (D. Masciandaro). 1062-9408/$ – see front matter © 2008 Elsevier Inc. All rights reserved. doi:10.1016/j.najef.2008.02.002

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the supervisory landscape less uniform than in the past. In several countries the architecture still reflects the classic model, with separate agencies for banking, securities and insurance supervision. However, an increasing number of countries show a trend towards consolidation of supervisory powers, which in some cases has culminated in the establishment of a unified regulator, either inside or outside the central bank.1 These changes in the supervisory architecture are taking place against the backdrop of fundamental changes in the financial markets. The financial industry is changing its conventional face, with a blurring of the traditional boundaries between banking, securities and insurance, and the formation of large conglomerates. The natural question that follows from a confrontation of these trends is: in a given country, is there any relationship between the shape of the supervisory regime and the evolving features of its financial industry? As a matter of fact, the authorities in the first eye-catching examples of this trend—the United Kingdom and Australia—explicitly justified the supervisory reorganization by referring to the changes in their financial industries along the lines indicated above.2 In other cases, such as South Africa, supervisory unification was seen as premature because the authorities did not see any clear trends of blurring of boundaries, or formation of conglomerates. Hence it was decided that bank supervision would remain with the Reserve Bank of South Africa and that supervision of all other subsectors would be unified in another, new agency (Bezuidenhout, 2004). This last example notwithstanding (and there are a few more), there has been a tendency in recent years among policy makers to allude to developments in their financial markets to justify a consolidation of supervisory powers. More generally, the idea that supervisory consolidation and unification is (in part) in response to the blurring and conglomeration trends in the financial sector has become common place in overview studies devoted to the recent evolution in supervisory design.3 However, against this widespread “belief” stands the finding that there is a general lack of theoretical underpinning and empirical evidence to corroborate the view that the structure of the financial markets plays a decisive role in shaping a country’s supervisory structure. The only empirical papers on the topic, Masciandaro (2006, 2007), find that when policymakers choose the supervision model, they actually seem to neglect some specific features of their financial markets (basically bank based versus market based setting). So the question regarding the importance of market features for the design of the supervisory structure remains broadly unanswered and this paper will explore the empirical linkages further. A second, related and equally relevant question in this debate, relates to the views of the supervised entities themselves on the supervisory architecture, and the extent to which these views are taken into account in the decision-making process. Systematic and empirical evidence in this domain too is rather scarce. Westrup (2007) is one of the few sources on the topic. He reports for instance that in Germany, at least one part of the financial sector representatives (represented in the Bunderverband Deutscher Banken, BdB) were in favor of a unified model outside the Bundesbank, and with a weaker degree of independence. This is one of the clearest examples of views expressed by the market at the time of a reform. Moreover, these views seem to have had an impact on the final decision. For the United Kingdom, in contrast, his research finds no evidence of explicit views expressed by the market actors at the time of the reforms. The Wallis Commission in Australia reports prior consultation with the financial sector on the reforms of the supervisory framework (Commonwealth of Australia, 1996). Beyond this, almost anecdotal, evidence we have little information on views from the market, and on their potential impact on the decision-making process in individual countries.

1 ˇ ak ´ For surveys of recent developments see, among others, De Luna Martinez and Rose (2003), Masciandaro (2005), and Cih and Podpiera (2007). 2 See among others, for the U.K. Briault (1999) and Davis (2004), and for Australia, Commonwealth of Australia (1996). Years before the current wave of supervisory restructuring started, the Nordic countries (Denmark, Norway and Sweden) had already established a unified supervisor. The high degree of concentration of their financial systems was also mentioned as a main reason for this reform (see among others, Taylor and Fleming (1999). 3 See, for example, Taylor and Fleming (1999) and the case studies collected in Masciandaro (2005).

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This paper offers two complementary contributions to the debate about the importance of the “market factor” in reshaping supervisory architectures. By “market factor” we understand hereafter the two elements referred to above: the structure of the markets and the views of the market participants (financial institutions).4 In the first part of the paper we take a political-economy view to explore the impact of market structure on the supervisory architecture. Since a purely economic view—represented in the selection of the “banks-versus-market” variable in Masciandaro (2006, 2007)—does not seem to yield clear results, we explore this issue from a political-economic point of view. From a theoretical point of view, at least two alternative theories can be formulated to explain the relationship between the structure of the markets and the supervisory architecture—the helping hand view (HHV) of government and the grabbing hand view (GHV).5 The main difference between the two is in whose interests the government is working. Under HHV, the policymaker’s choices are motivated by improving general welfare. Therefore, it is possible to claim that their efforts to reform the supervisory structure aim at improving the efficiency of overall resource allocation, and that the market features are an important factor to be taken into consideration. According to the GHV approach, the policymakers are motivated by the aim to please the interest of specific, well-defined voters. In our case, the financial industry may be considered a highly organized and powerful interest group. The financial industry is likely to be a smaller and more coherent group than the consumers of their services, and therefore politically better organized. The policymaker, in defining the supervisory setting, is likely to be influenced by the market view of supervision, if this increases the probability of his/her re-election. Therefore the market view becomes the crucial variable in determining the shape of the supervisory regime if we use the grabbing hand approach. This theoretical approach is further discussed in our paper and empirically tested in a crosscountry setting. The second part of the paper starts from the view that the opinion of the market participants regarding the supervisory architecture is also an important aspect to study. Understanding the market preferences can be useful to predict either the effectiveness and/or the likelihood of a supervisory regime. Again, this issue has not been addressed systematically in the literature. So here we present and analyze the results of a survey, held in 2006 among CEOs of Italian financial institutions, about their preferences and beliefs on supervisory structure and regulatory governance and their views on the political decision-making process. This paper is structured as follows. Sections 2 and 3 disentangle the two opposite theories (HHV and GVH) on the determinants of emerging supervisory structures with special attention for the role of the market factor in the decision-making process. Section 2 discusses the background to our analysis in the context of the HHV versus GHV hypotheses, and Section 3 reports on our empirical tests. In Section 4 we discuss the survey on market views. Section 5 brings the main conclusions together. 2. Do markets matter in designing financial supervision architectures? Helping hand view versus grabbing hand view Do the features of financial markets matter in determining the shape of the supervisory regime? The relevance of this question is of a recent date. Until roughly 15 years ago, the issue of supervisory architecture was considered irrelevant. First of all, the fact that only banking systems were considered needing supervision made several of the current organizational questions meaningless. In such a context, the supervisory design was either considered deterministic (i.e., it is an exogenous variable), or accidental (i.e., it is a completely random variable).6 The situation has changed. The changes in the financial markets, resulting in the growing systemic importance of insurance, securities and pension fund sectors have made supervision of all segments of the financial system important, and raise the issue as to whether the newly emerging financial

4 Depositors and clients of other financial institutions are of course also market participants in the broader sense of the word, but we will limit ourselves to the narrower definition and we will refer to “depositors” when we discuss them explicitly. 5 The helping hand view goes back to Pigou (1938) and the grabbing hand view was first elaborated by Shleifer and Vishny (1998). 6 For an historical perspective, see the discussion in Goodhart (2007) and Capie (2007).

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supervisory structures are endogenous, i.e., designed in response to these developments and other factors. Our starting point to answer the above question is based on three crucial hypotheses. First of all, we claim that gains and losses of a supervisory model7 are variables calculated by the policymaker in charge, who decides to maintain or reform the supervisory regime.8 Second, the decisions of policymakers, whatever their own specific goals are, will likely be influenced by structural variables—such as the features of the financial markets—that may vary from country to country. We wish to test the hypothesis that in every country, given the structural endowment, these variables can determine, ceteris paribus, the gains or losses policymakers expect from a specific supervisory regime. The supervisory regime is the dependent variable. Finally, economic agents have no information on the true preferences of the policymaker: the latter’s optimal degree of financial supervision concentration is a hidden variable.9 The crucial element in considering the policymaker’s objective as a factor in the design of the supervisory architecture is the identification of his/her preferences. The first approach to identifying the policymaker’s function could be the so-called narrative approach, in which official documents and statements are interpreted to gauge the choices of policymakers.10 One drawback of this approach is that there is often substantial room for differences between the pronouncements of policymakers and their actual preferences. The second approach, which we intend to follow here, is to consider the actual choices of policymakers in determining the level of financial supervision concentration (factual approach). At each point in time, we observe the policymaker’s decision to maintain or reform the financial supervision architecture. In other words, we consider that policymakers are faced with discrete choices. According to the factual approach, we can investigate if the features of the financial markets play any role in determining the actual shape of the supervisory architecture. By taking a political economy view, we can test the hypothesis that politicians may wish to use reform (or status quo) to gain or keep influence through the supervisory process.11 The relevant players in our theoretical framework are the policymakers, the community and the financial constituency. First of all, we focus our attention on the behavior of the policymakers. We will explore two alternative views—the helping hand view of government and the grabbing hand view—which share a common premise: the policymakers are politicians, i.e., they are “career concerned” agents, motivated by the goal of pleasing the voters in order to win the elections.12 The main difference concerns which voters—general interest versus vested interest—they are trying to please. Consequently the second relevant player is the community, i.e. the citizens. Market economies are committed to financial stability in order to maximize long term welfare. Given the high costs in terms of resource misallocation, informational losses and taxpayer bailouts that financial instability can cause, citizens have an interest in the soundness of the financial and banking system and prefer to avoid generalized unexpected negative shocks in the financial industry. In the banking sector, the generalized unexpected negative shocks have a precise name – systemic crises – and a well defined class whose interests would be adversely affected by the emergence of such a shock: the public in the

7 ˇ ak ´ For an analysis of pros and cons of alternative models of supervision see, among others, Arnone and Gambino (2007), Cih and Podpiera (2007), Di Giorgio and Di Noia (2007). See also Section 5 below. 8 The importance of the policymakers’ preferences in explaining how supervisory settings come about can be tackled in different ways. For example, the political economy of financial regulation can be analyzed as the outcomes of conflicts which are linked to inclusive and exclusive processes. See Mooslechner, Schubert, and Weber (2006) and in particular Lutz (2006). 9 By financial supervision concentration we refer to the degree of integration or consolidation of the supervisory function. At one end of the spectrum are those countries that have several sector-specific supervisory agencies; at the other end of the spectrum are the countries that have established a unified supervisor. See Section 3 for more details. 10 The narrative approach has been used in, for instance, Westrup (2007). 11 For instance, a majority of commentators agree that the government’s decision to establish a unified regulator in Poland in 2006 was mainly meant to curb the central bank’s power and to regain some government influence over financial sector developments. See for instance remarks and citations in Dow Jones Commodities Service (September 14, 2006), Agence France Press (September 29, 2006), and Associated Press Newswires (October 3, 2006). 12 Alesina and Tabellini (2003) stressed that the lines of accountability represent the main difference between politicians and bureaucrats: politicians are held accountable at the elections, while bureaucrats are accountable to their professional peers or to the public at large.

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form of depositors and/or taxpayers. The citizens like a supervisory architecture effective in minimizing the risks of financial instability. In terms of a contracting approach, the delegation of the task to the policymakers creates a contract between them and depositors/taxpayers. The terms of this contract are that in establishing a supervisory regime, the policymaker acts as an agent on behalf of depositors/taxpayers whose preference is for long-run stability in the financial system. The peculiarity of this contract is that the effectiveness of the supervisory design is observable only ex post, but not contractible ex ante. If the level of effectiveness cannot be defined ex ante – the optimal level of financial stability so far is not defined in the literature – the policymaker cannot be rewarded directly through an explicit and verifiable contract. The policymaker can be rewarded based only on observed ex post performances of the chosen supervisory regime. Masciandaro, Quintyn, and Taylor (2007) and Quintyn (2007) broadly discuss how, other things being equal, the degree of discretion of the policymaker in building up a supervisory regime is greater, compared to other institutional designs (for example, to implement a monetary regime characterized by an independent central bank aimed to pursue monetary stability). However, merely delegating the specialized task to the policymakers will not produce automatically the social optimal outcome if these same policymakers are subject to “capture”. A strand in the literature, which derives from Stigler (1971), stresses that every regulator is likely to be captured by private interests in the sense that a policymaker which is supposed to be acting in the public interest can be dominated by vested interests of the existing incumbents in the industry that it oversees. In public choice theory, regulatory capture arises from the fact that vested interests have a concentrated stake in the outcomes of policy decisions, thus ensuring that they will find means—direct or indirect—to capture decision makers. In the case of the supervisory setting, industry capture can influence the policymakers, who will design the regime consistent with the preferences of the financial industry. Therefore the third relevant player is the financial community. In a policy game in which the incumbent policymaker may please two different constituencies, we can identify two different types of government. 2.1. Helping hand view In general, the “helping hand” (HH) policymaker – i.e., a government that aims to maximize social welfare – wishes to correct or prevent market imperfections.13 In the case of designing the financial supervision regime, the HH policymaker can choose to maintain or reform the degree of supervisory concentration in order to improve the overall efficiency in resource allocation, and therefore he/she has to take into account the structure of the financial system. The crucial stylized fact in this regard is the blurring of boundaries in the financial industry which is leading to an increasing integration of the banking, securities and insurance markets, as well as their respective products and instruments. The blurring effect has caused two interdependent phenomena: (i) the emergence of financial conglomerates, which is likely to produce important changes in the nature and dimensions of the individual intermediaries, as well as in the degree of unification of the banking and financial industry; and (ii) growing securitization of the traditional forms of banking activity and the proliferation of sophisticated ways of bundling, repackaging and trading risks, which weakens the classic distinction between equity, debt and loans, and is bringing changes in the nature and dimensions of the financial markets. The HH policymaker recognizes that the supervisory architecture was created for a structure of the financial system that is no longer consistent with these structural changes. The supervisory boundaries no longer reflect the actual features of the financial industry. The question of the institutional setting of supervision becomes a policy issue. In particular, the HH policymaker wonders if a unification in supervision has to follow the blurring trends in the markets. In other words, should supervisory

13 Pigou (1938). Although the helping hand view was identified by Pigou as the government’s way to address market imperfections and enhance social welfare, it has been pointed out that this view of the government can also lead to excesses. Barth, Caprio, and Levine (2004) point out that the helping hand view can stimulate the introduction of regulations that in fact choke financial sector development, such as entry restrictions and limits on activities.

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activities be integrated, through the establishment of a single financial regulator? In general, the HH policymaker will find advantages and disadvantages in the establishment of a unified financial sector supervisor.14 Potential benefits of unification include a more efficient and effective control of financial conglomerates and financial markets in a state of flux. By providing more effective supervision the HH policymaker would please the financial consumers—i.e., the citizens—by contributing to the existence of a stable financial environment in the hopes of increasing the probability of winning future elections. The views expressed by the market participants on the optimal structure of supervision could become an important factor in the discussion on improving efficiency and effectiveness of financial supervision. From the point of view of the market participants a unified supervisor could solve problems of duplication, overlap and inconsistency in controls and reporting requirements, and regulatory gaps. It could also increase the possibility of having a level playing field, characterized by competitive neutrality. In other words a unified supervision could mean a decrease in the expected compliance costs. If the market participants like more concentrated supervision, a closer alignment between general interest (effective supervision) and specific (market participants) interest (efficient supervision) is more likely to occur. Therefore, the HH policymaker can be sensitive to the market view. 2.2. Grabbing hand view The “grabbing hand” (GH) policymaker is also an elected politician, for which he/she has to please the voters. But now we consider the case of lobbies, that can influence the policymaker’s choices. In contrast with the HH policymaker, the GH government would tend to give benefits only to a small but well organized interest group. The GH policymaker is captured by a specific interest group, whose support is considered fundamental for (re)election.15 We can suppose that, while the common voters can influence the policymaker only through elections, the vested interest group can influence the policymaker through explicit or implicit contributions, important enough to increase the chances of winning the elections. In this case the preferences of the interested group would become the fundamental variable in explaining the policy choices. Faced with the issue of (re)shaping the architecture of financial supervision, the GH policymaker can be influenced by the market features, but – more importantly – he/she will most likely be sensitive to the preferences of the market participants. The demand by the financial industry for more consolidated supervision can be a disguised form of capture. Capture is more likely to occur: (i) the greater the level of concentration in the financial industry is; and (ii) the more the number of supervisory authorities decreases. In these circumstances, if premises (i) and (ii) together hold, the establishment of a single financial authority can become an institutional deficiency from a social welfare point of view, and undermine effectiveness and efficiency of supervision. Let us summarize the main findings. How important is the market factor – i.e. the structure of the financial markets and the views of the market participants – in explaining the trend toward more integrated supervision? We imagined the design of the financial supervision regime as a delegation problem, where the incumbent policymaker – the agent – in order to maximize his/her probabilities of re-election can choose to please the citizens (HH type), or the financial industry (GH type). The HH policymaker can consider the market factor just one element to take in consideration, while for the GH policymaker the market factor is the crucial variable in the decision-making process. We discussed under which conditions each type of policymaker can choose a more integrated supervisory regime. Now can we disentangle the effect of different type of policymakers on the relationship between the financial supervision unification and the market factor? Let us focus in the following section on the role of the market structure.

ˇ ak ´ and Podpiera (2007). Abrams and Taylor (2002), Arnone and Gambino (2007), Cih We use the terminology of the regulatory capture theory – Stigler (1971) – to describe a situation where both policymaker and industry pursue their own benefits, rather than social welfare. 14

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3. Does the market structure matter? To assess empirically the role of the market structure in determining the degree of concentration in the financial supervision architecture from the perspective of these two alternative views, we estimate a model of the probability of different regime decisions as a function of a set of exogenous structural variables. To that effect, we use the approach introduced in Masciandaro (2006, 2007). Weaving a crosscountry perspective into an empirical analysis consistent with this discrete choice process involves claiming the existence of unobservable policymaker utilities Uij , where each Uij is the utility received by the ith national policymaker from the jth level of supervision consolidation. Since the utility Uij is unobservable, we represent it as a random quantity, assuming that it is composed of a systematic part U and a random error term ε. Furthermore, we claim that the utilities Uij are a function of the attributes of the alternative institutional level of supervision consolidation and the structural characteristics of the policymaker’s country. By combining the two hypotheses, we have a random utility framework for the unobservable supervision consolidation variable. As usual, we assume that the errors εij are independent for each national policymaker and institutional alternative, and normally distributed. The independence assumption implies that the utility derived by one national policymaker is not related to the utility derived by a policymaker in any another country, and that the utility that a policymaker derives from the choice of a given level of financial consolidation is not related to the utility provided by the other alternative. Therefore, supervisory regimes can be viewed as resulting from an unobserved variable: the optimal degree of financial supervision consolidation, consistent with the policymaker’s utility. Each regime corresponds to a specific range of the optimal financial supervision consolidation, with higher discrete values of a given index corresponding to a higher range of financial unification values. We use the Index of Financial Authorities Concentration (FAC) proposed in Masciandaro (2004). This index was created through an analysis of which, and how many, authorities in the 88 countries examined are in charge of supervising the three traditional sectors of financial activity: banking, securities markets and insurance.16 The country sample depends on the availability of institutional data.17 To transform the qualitative information into quantitative indicators, we assigned a numerical value to each type of regime, in order to highlight the number of the agencies involved. The rationale by which we assigned the values considers simply the concept of unification of supervisory powers: the greater the unification, the higher the index value. The index was built on the following scale: 7 = single authority for all three sectors (total number of supervisors = 1); 5 = single authority for the banking sector and securities markets (total number of supervisors = 2); 3 = single authority for the insurance sector and the securities markets, or for the insurance sector and the banking sector (total number of supervisors = 2); 1 = specialized authority for each sector (total number of supervisors = 3). We assigned a value of 5 to the single supervisor for the banking sector and securities markets because of the predominant importance of banking intermediation and securities markets over insurance in every national financial industry. It also interesting to note that, in the group of integrated supervisory agency countries, there seems to be a higher degree of integration between banking and securities supervision than between banking and insurance supervision1 ; therefore, the degree of concentration of powers, ceteris paribus, is greater. These observations do not, however, weigh another qualitative characteristic: there are countries in which one sector is supervised by more than one authority. It is likely that the degree of concentration rises when there are two authorities in a given

16 Sources: for all countries, official documents and websites of the central banks and the other financial authorities. The information is updated to 2006. See Table 1. 17 In the empirical analysis we do not include nine very small countries and territories (Bahrain, Bermuda, Cayman Islands, Gibraltar, Hong Kong Maldives, Netherlands Antilles, Singapore and United Arab Emirates) with a single financial authority in order to avoid an evident bias in the empirical analysis.

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sector, one of which has other powers in a second sector. On the other hand, the degree of concentration falls when there are two authorities in a given sector, neither of which has other powers in a second sector. It would therefore seem advisable to include these aspects in evaluating the various national supervisory structures by modifying the index as follows: adding 1 if there is at least one sector in the country with two authorities, and one of these authorities is also responsible for at least one other sector; subtracting 1 if there is at least one sector in the country with two authorities assigned to supervision, but neither of these authorities has responsibility for another sector; 0 elsewhere. There are five qualitative characteristics of supervisory regimes that we decided not to consider in constructing this index. Firstly, we do not consider the legal nature – public or private – of the supervisory agencies nor their relationship to the political system (degree of independence, level of accountability18 ). Secondly, at least in each industrial country, there is an authority to protect competition and the market, with duties that include the financial sector. Since it is common to all the structures, we decided not to take into account the antitrust powers in constructing the index. Besides we do not consider who is involved in the management of the deposit insurance schemes. In general, we consider only supervision of the three traditional sectors (banking, securities and insurance markets). Finally, financial authorities may perform different functions in the regulatory and the supervisory area. At this first stage of the institutional analysis, we prefer to consider only the number of the agencies involved in the supervisory activities. Since the FAC Index is a qualitative ordinal variable, the estimation of a model for such a dependent variable necessitates the use of a specific technique. Our qualitative dependent variable can be classified into more than two categories, given that the FAC Index is a multinomial variable. But the FAC Index is also an ordinal variable, given that it reflects a ranking. Then the ordered model is an appropriate estimator, given the ordered nature of the policymaker’s alternative. Let y be the policymaker’s ordered choices taking on the values (0, 1, 2, . . ., 7). The ordered model for y, conditional on a set of K explanatory variables x, can be derived from a latent variable model. In order to test this relationship, let us assume that the unobserved variable, the optimal degree of financial supervision consolidation y*, is determined by: y∗ = ˇ x + ε where ε is a random disturbance uncorrelated with the regressors, and ˇ is a 1 × K regressors’ vector. The latent variable y* is unobserved. What is observed is the choice of each national policymaker to maintain or to reform the financial supervisory architecture. This choice is summarized in the value of the FAC Index, which represents the threshold value. For the dependent variable we have seven threshold values. Estimation proceeds by maximum likelihood, assuming that ε is normally distributed across country observations, and the mean and variance of ε are normalized to zero and one. This model can be estimated with an ordered model. On the basis of this framework, we can analyze the role of the market features in the determination of the supervisory architecture. In spite of the contrast between both views, they remain difficult to disentangle from an empirical point of view, among others because it is not easy to find empirical variables that consistently and unambiguously represent each of these two approaches. 3.1. Review of existing evidence We start this section by recalling the results from the model developed in Masciandaro (2006, 2007). The model identified six potential determinants of the financial supervision regime. The determinants and their proxies are described on Table 1. First, the probability that a country will move toward a more concentrated form of supervision may depend on the overall size of the nation, highlighting a small country effect: whatever the policymaker type, with relatively few people the expertise in financial supervision is likely to be in short supply, and concentration is more likely to occur (economic factor: its proxy is the gross national product).

18

¨ On these issues, see Quintyn and Taylor (2003) and Hupkes, Quintyn, and Taylor (2005).

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Table 1 Data sources Variable

Symbol

Definition

Data sources

Financial Authorities Concentration Index

FAC

(4)

Central Bank as Financial Authority Index

CBFA

Good governance

Gov

GDP

GDP

Market versus banked systems

MVB

Conglomeration

n/a

Concentration

n/a

European Union

EU

OECD

OECD

Reform Year

Reform

Common Law, Civil Law

Com, Civ

Section 3 see also Masciandaro (2007) for further details Section 3 see also Masciandaro (2007) for further details The index is built using all the indicators proposed by Kaufmann et al. (2003). Average values 1996, 1998, 2000, 2002, 2004 GDP. Average values: 1996, 1998, 2000, 2002, 2004 Market versus bank-based countries. Dummy variable computed using different banking and ¨ ¸ -Kunt, & financial variables: see Beck, Demirguc Levine (2000) for further details. Average values 1996, 1998, 2000, 2002, 2004 The variable is derived from the database contained in Caprio–Levine and corresponds to their question 2.4 The variable is constructed as the percentage of total deposits held by the five largest banks in the country. The variable is derived from question 2.6.2 of the new database constructed by Caprio–Levine Dummy that signals whether a given country is a member of the European Union or not Dummy that signals whether a given country is a member of the OECD or not Year of the last reform of the supervision architectures Legal origin of countries. See Beck, Demirguc-Kunt and Levine (2001) for details

(4) (5)

(6) (6) and (1)

(3)

(2)

(7) (7) (4) (7)

(1) Bankscope; (2) Beck et al. (2000); (3) “How countries supervise their banks, insurances and securities markets 2006”, Central Banking Publications Ltd., UK. Central Banks Websites. Richmond Law & Tax, Ldt. 2005; (4) Kaufmann et al. (2003); (5) World Development Indicators, World Bank; (6) World FactBook, CIA.

Second, the choice of the policymaker regarding how many institutions are to be involved in supervision seems to be related to the traditional role played by the central bank in the supervisory process (central bank factor: its proxy is the central bank involvement in supervision). To measure the importance of the role the central bank plays in the various national supervisory regimes, we use the index of the central bank’s involvement in financial supervision: the Central Bank as Financial Authority Index (CBFA) (Table 1). For each country, and given the three traditional financial sectors (banking, securities and insurance), the CBFA Index is equal to: 1 if the central bank is not assigned the main responsibility for banking supervision; 2 if the central bank has the main (or sole) responsibility for banking supervision; 3 if the central bank has responsibility in any two out of the three sectors; 4 if the central bank has responsibility in all three sectors. In evaluating the role of the central bank in banking supervision, we considered the fact that, whatever the supervision regime, the monetary authority has responsibility in pursuing macro financial stability. Therefore the relative role of the central bank is the rule of thumb: we assigned a greater value (2 instead of 1) if the central bank is the sole or the main authority responsible for banking supervision. It is interesting to note that in general the present degree of the central bank involvement has been established in the years before, and then confirmed in subsequent reforms. For each country we compare the year in which the present degree of central bank involvement in supervision was established (i.e. definition of the CBFA Index), with the year of the most recent reform of the supervisory architecture (i.e. definition of the FAC Index). Given data of 88 national reforms of the supervisory architecture, the central bank involvement was confirmed in 67 cases (76%), decreased in 16 cases (18%), increased only in 5 cases (6%).

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Third, the quality of the political environment could be important in determining the policymaker’s choice (political factor; its proxy is the level of good governance), as well as the legal system (legal factor; its proxies are Common Law and Civil Law), the geographical location (geographical factor; its proxy is Europe), or the membership in international organization (international factor: its proxy is OECD). Finally, the policymaker can choose to maintain or change the degree of supervisory unification in response to the structure of the financial system (market factor). The market factor is captured by using the classic comparison between the equity dominance model (or market-based regime) and the bank dominance model (or bank-based regime). The sample was made of 88 countries belonging to all continents. Most of the data have been collected using World Bank Surveys and public Official documents (see Table 1). The results of the estimates showed that the probability that a country will move toward a single authority model is higher: (i) the smaller the size of the economy (small country effect)19 ; (ii) the lesser the central bank is involved in supervision before the reform (path dependence effect); and (iii) when the jurisdiction operates under the Civil Law—particularly if the legal framework is characterized by German and Scandinavian roots (law effect).20 The market factor does not matter. 3.2. New evidence This section attempts to further the analysis of the role of the market factor by testing three innovations to the basic model. First the original database of the general model is updated by calculating the level of the structural macro variables: gross domestic product and good governance.21 Tables 2 and 3 show the logit and probit estimates of the basic equation with the new database. The results confirm the robustness of two main determinants: the institutional factor and the law factor. The market factor is still not significant. Second, since we are studying general trends among policymakers in reforming supervision, rather than a specific trend in consolidation, we can ask ourselves if there is some kind of “bandwagon effect” at work among the policymakers. The policymaker in a given country implements a reform of the supervisory framework, because policymakers in other countries did or are doing the same thing, in other words, because it is becoming fashionable. To test the bandwagon effect, we construct a new variable: for each country, we compute the year in which the last reform in supervision was implemented (Reform Year). The hypothesis is that, with a bandwagon effect, recent reforms are likely to correspond to higher level of consolidation.22 Table 4 shows that the new variable is not significant. This finding seems to confirm an activism on the part of the policymakers in reforming the supervisory architecture, rather than a simple mimicking of the establishment of a single regulatory authority in other countries. So, while there might be some form of demonstration effect—reforming because others are reforming—it is certainly not clear from the above finding that the model of complete integration is being copied because it seems fashionable. The third step addresses the question as to which type of policymaker is in action. To take into account the predictions of both the HH and the GH types, we have to identify new indicators, given that, under this perspective, the above “market oriented versus bank oriented” variable alone is not sufficient to discriminate between the two views.

19 This finding is consistent with the so-called small open economy-argument for unification of the supervisory functions. The argument was first developed by Taylor and Fleming (1999) in their analysis of the Scandinavian experience with supervisory integration in the late 1980s and early 1990s. The argument has later been used by other countries to justify the establishment of a unified supervision (for examples, see contributions in Masciandaro (2005)). 20 On the law and finance approach see La Porta et al. So far the testing of the legal origins effect produced mixed results in the empirical works. In Masciandaro (2006) the legal origin effect disappeared when different classifications of legal origins are used while in Masciandaro, 2007, with a different sample size, the legal origin effect holds using the alternative classifications. 21 Masciandaro (2006, 2007) used for each of the two variables the mean of four years: 1996, 1998, 2000, 2002. Here we compute the mean by adding a fifth value: 2004. The source is the same: World Bank. 22 We acknowledge that the Reform Year variable is a fairly imperfect proxy for a possible bandwagon effect. The best way to calculate this effect would be the construction of an index of the change in each country in the level of supervision consolidation before and after the last reform.

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Table 2 Choice of supervisory unification – ordered logit estimation: basic model with new data Dependent variable: FAC index (a)

(b)

(c)

(d)

(e)

CBFA Index

−0.750** −0.29

−0.681** −0.3

−0.738** −0.31

−0.725** −0.31

−0.769** −0.32

GDP

−0.00022 −0.00016

−0.00029 −0.00019

−0.00028 −0.00018

−0.0003 −0.00019

−0.0003 −0.0002

Common Law

0.974 −0.62

0.505 −0.65

0.719 −0.7

0.753 −0.7

0.636 −0.71

Civil Law

1.577*** −0.51

1.315** −0.51

1.369*** −0.52

1.370*** −0.52

1.394*** −0.52

0.850*** −0.26

0.673** −0.34

0.565 −0.41

0.573 −0.4

0.492 −0.6

0.406 −0.62

0.553 −0.64

0.328 −0.69

0.104 −0.73

Good Governance EU OECD Markets vs Banks

0.469 −0.52

Number of observations: 88; standard errors in parentheses; *significant at 10%; **significant at 5%; ***significant at 1%.

The HH policymaker, in order to increase the efficiency in resource allocation, will address the two most striking financial sector phenomena: the formation of conglomerates and securitization of financial products. However, the role of market trends in influencing the policymaker’s decisions is not unequivocal, given that – as we highlighted above – the optimal model of supervision is still to be discovered, and ex-ante a more consolidated supervisory setting can produce either advantages or disadvantages. Therefore, given the market structure, the expected sign of a relationship between the Table 3 Choice of supervisory unification – ordered probit estimation: basic model with new data Dependent variable: FAC index (a)

(b)

(c)

(d)

(e)

CBFA Index

−0.373** −0.16

−0.331** −0.16

−0.354** −0.16

−0.350** −0.16

−0.354** −0.16

GDP

−0.00014 −9.2E−05

−0.000180* −9.3E−05

−0.000174* −9.3E−05

−0.000181* −9.6E−05

−0.000181* −9.6E−05

Common Law

0.426 −0.34

0.145 −0.36

0.265 −0.38

0.273 −0.38

0.223 −0.39

Civil Law

0.853*** −0.29

0.697** −0.29

0.747** −0.3

0.743** −0.3

0.752** −0.3

0.545*** −0.15

0.436** −0.19

0.397* −0.23

0.405* −0.23

0.308 −0.34

0.278 −0.36

0.321 −0.36

0.121 −0.39

0.0353 −0.42

Good Governance EU OECD Markets vs Banks

0.186 −0.3

Number of observations: 88; standard errors in parentheses; *significant at 10%; **significant at 5%; ***significant at 1%.

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Table 4 Choice of supervisory unification – ordered logit and probit estimation: bandwagon effect Dependent variable: FAC index

CBFA Index GDP Common Law Civil Law Good governance EU OECD Reform Year

Logit

Probit

−0.721** (−0.31) −0.0003 (−0.00019) 0.753 (−0.7) 1.355** (−0.53) 0.566 (−0.41) 0.427 (−0.64) 0.322 (−0.69) −0.00157 (−0.012)

−0.349** (−0.16) −0.000181* (−9.6E−05) 0.274 (−0.38) 0.736** (−0.31) 0.398* (−0.23) 0.288 (−0.37) 0.118 (−0.39) −0.00088 (−0.007)

Number of observations: 88; standard errors in parentheses; *significant at 10%; **significant at 5%; ***significant at 1%.

degree of supervision concentration and a proxy of the new financial trends is undetermined – i.e., can be positive or negative – and remains an empirical question. At the same time, the HH policymaker is by definition immune with respect to any risks of capture. The GH policymaker will be sensitive to the preferences of the market participants, irrespective of the actual trends in the financial markets. As we already noted, the demand of the financial industry for more consolidated supervision can hide a risk of capture. Provided that the market participants like a unified supervisory model, and given the market structure, the expected sign of a relationship between the degree of supervision concentration and a proxy of the capture risk is positive. Thus, the predictions of the theory regarding the two types of policymakers are different, although a degree of ambiguity cannot be eliminated. Given the policymakers’ opposite profiles, we can first test the effect of an indicator of market trends: the conglomeration effect. The relationship between the supervisory unification and the conglomeration effect (Conglomeration) is more likely to be significant if the policymaker is a HH type. Secondly, we can test the consequences of a proxy of the capture risk: the degree of consolidation in the financial industry. The relationship between supervisory unification and the degree of concentration of the financial system (Concentration) is more likely to be significant if the policymaker is a GH type. In addition, provided that the market participants prefer a unified supervisory model, the expected sign of the relationship is positive. That the two measures of the market factor are different, at least in our sample, is confirmed by their low positive correlation coefficient (0.0519). Due to limited data availability on these two variables, the size of the original country sample is reduced from 88 countries to 51 countries for the conglomeration effect. The results are reported in Tables 5 and 6. Table 5 shows that the conglomeration effect is not significant. In addition, the overall specification looses significance. In contrast, the results in Table 6 signal that the concentration effect is always positive and significant. Furthermore, the relevance of the institutional factor and the law factor are confirmed in this specification. Table 5 Choice of supervisory unification – ordered logit and probit estimation: conglomeration effect Dependent variable: FAC index

CBFA Index GDP Common Law Civil Law Good governance EU OECD Conglomeration Effect

Logit

Probit

−0.533 (−0.43) −0.00025 (−0.0002) 0.892 (−1) 1.408* (−0.78) 0.894 (−0.59) 0.92 (−0.97) −0.536 (−0.84) 0.0092 (−0.0077)

−0.234 (−0.22) −0.00015 (−0.00011) 0.334 (−0.54) 0.802* (−0.45) 0.677** (−0.34) 0.437 (−0.52) −0.331 (−0.46) 0.00631 (−0.0046)

Number of observations: 88; standard errors in parentheses; *significant at 10%; **significant at 5%; ***significant at 1%.

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Table 6 Choice of supervisory unification – ordered logit and probit estimation: concentration effect Dependent variable: FAC index

CBFA Index GDP Common Law Civil Law Good governance EU OECD Concentration effect

Logit

Probit

−0.689** (−0.32) −0.00021 (−0.0002) 0.806 (−0.7) 1.487*** (−0.53) 0.51 (−0.4) 0.351 (−0.63) 0.397 (−0.69) 2.141* (−1.22)

(−0.16) −0.00013 (−0.0001) 0.345 (−0.39) 0.824*** (−0.31) 0.36 (−0.23) 0.258 (−0.36) 0.169 (−0.39) 1.341* (−0.72)

Number of observations: 88; standard errors in parentheses; *significant at 10%; **significant at 5%; ***significant at 1%. Table 7 Choice of supervisory unification – ordered logit and probit estimation: alternative indicator Dependent variable: FAC two index

CBFA Index GDP Common Law Civil Law Good governance EU OECD Concentration effect

Logit

Probit

−1.484*** (−0.41) 8.02E−05 (−0.00017) 1.327 (−0.81) 1.198* (−0.62) 0.185 (−0.44) 1.07 (−0.68) 0.47 (−0.74) 2.816** (−1.43)

−0.711*** (−0.19) 0.000039 (−0.00011) 0.772* (−0.46) 0.718** (−0.36) 0.169 (−0.25) 0.601 (−0.39) 0.289 (−0.42) 1.600* (−0.83)

Number of observations: 88; standard errors in parentheses; * significant at 10%; ** significant at 5%; *** significant at 1%.

Tables 7 and 8 report on a number of robustness tests, which test different definitions of the dependent variable. First of all, we eliminated the weights attributed to the banking and financial supervisory responsibility with respect to the insurance sector supervision.23 The concentration effect holds, as well as the institutional effect and the law effect (Table 7). Secondly we tested a more radical hypothesis: each policymaker simply decides between the two extreme regimes of supervision, single authority (complete centralization) versus multi-authority (decentralization). The dependent variable became a dummy, to be estimated using simple logit and probit. Again the concentration effect and the institutional effect are significant, and the geographical effect becomes relevant again (Table 8). Finally we consider the issue of causality. Let us highlight that the tests examine the supervisory structure at time t (year 2006), analyzing if a set of structural variables defined at t − 1 is relevant in explaining the supervisory shape. The dependent variable is obviously lagged compared to the law, geographical and international factors, and in the above section we also showed that the institutional factor (central bank involvement in supervision) is in general established at t − 1. The other two control variables—the economic factor and the political factor—were defined as average values in the period 1996–2004. The same methodology was used for the banking concentration variable, the only relevant proxy of the market factor. In general, the way the explanatory variables were constructed minimized the risks of reverse causality. Focusing on these three contemporary independent variables, the political factor can influence the market factor. Therefore we controlled for an interaction effect between the governance variable and the concentration variable: both the institutional factor and the law factor remain significant, while the market factor is significant only in the probit test (Table 9), without any role for interaction. We

23 We used an index (FAC Two) according to the following scale: 5 = single authority for all three sectors (total number of supervisors = 1); 3 = single authority for two sectors (total number of supervisors = 2); 1 = specialized authorities for each sector (total number of supervisors = at least 3). The correlation between FAC and FAC Two is 0.92.

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Table 8 Choice of single financial authority – logit and probit estimation Dependent variable: binary index

CBFA Index GDP Common Law Civil Law Good governance EU OECD Concentration effect Constant

Logit

Probit

−1.989*** (−0.69) 0.00027 (−0.00025) 0.845 (−1.39) 1.005 (−0.96) 0.121 (−0.68) 2.225** (−0.95) 0.859 (−1) 3.969* (−2.3) −3.440* (−2.05)

−0.969*** (−0.31) 0.000122 (−0.00015) 0.721 (−0.79) 0.652 (−0.56) 0.0458 (−0.39) 1.324** (−0.55) 0.545 (−0.58) 2.127* (−1.29) −2.182* (−1.12)

Number of observations: 88; standard errors in parentheses; * significant at 10%; ** significant at 5%; *** significant at 1%. Table 9 Choice of supervisory unification – ordered logit and probit estimation: interaction effects Dependent variable: FAC index

CBFA Index GDP Common Law Civil Law Good governance EU OECD Concentration effect Interaction effect (good governance × concentration effect)

Logit

Probit

−0.694** (−0.32) −0.0002 (−0.00019) 0.841 (−0.71) 1.478*** (−0.53) 0.0305 (−1.01) 0.391 (−0.64) 0.428 (−0.7) 1.875 (−1.33) 0.681 (−1.32)

−0.338** (−0.16) −0.00012 (−0.0001) 0.346 (−0.39) 0.817*** (−0.31) 0.224 (−0.61) 0.263 (−0.36) 0.18 (−0.4) 1.280* (−0.76) 0.194 (−0.8)

Number of observations: 88; standard errors in parentheses; * significant at 10%; ** significant at 5%; *** significant at 1%. Table 10 Choice of supervisory unification – ordered logit and probit estimation: interaction effects Dependent variable: FAC index

CBFA Index GDP Common Law Civil Law Good governance EU OECD Concentration effect Interaction effect (GDP × concentration effect)

Logit

Probit

−0.613* (−0.32) −0.00113* (−0.00061) 0.835 (−0.71) 1.438*** (−0.53) 0.563 (−0.41) 0.217 (−0.64) 0.338 (−0.69) 1.925 (−1.23) 0.00234 (−0.0015)

−0.311* (−0.16) −0.000655* (−0.00038) 0.349 (−0.39) 0.781** (−0.31) 0.396* (−0.23) 0.182 (−0.36) 0.129 (−0.39) 1.231* (−0.73) 0.00137 (−0.00094)

Number of observations: 88; standard errors in parentheses; * significant at 10%; ** significant at 5%; *** significant at 1%.

obtained similar results, controlling for the possible interaction effect produced by the scale factor (Table 10). Finally, we considered the fact that the governance variable is a composite one, summarizing six different indices: voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, control of corruption.24 Therefore, instead of the overall governance variable, we used each index as control variable. Consistent with previous findings, the institutional factor, the law factor and the market factor remain significant, but none of the governance indices is significant (with the exception of just one case: a weak positive relationship with political stability in the probit test). 24

See Kaufmann, Kraay, and Mastruzzi (2003).

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In conclusion, the new result from the empirical work in this paper is that the behavior of policymakers in reforming supervisory structures is more consistent with the GHV than the HHV, if one assumes that the degree of banking concentration is a reliable proxy for the political influence exerted by the financial industry, and presuming a market preference toward supervisory consolidation. More research is certainly needed to arrive at more robust conclusions. The key here is to identify better proxies for the market features that are considered relevant in the politicians’ decision-making process. 4. Case study: the market view in Italy Information on the views of the market participants regarding the desirable supervisory architecture and its governance structure is not generally and systematically available. Thus far, researchers have to rely more on anecdotal evidence. As indicated earlier, Westrup (2007) reports that in Germany, at least one part of the financial sector representatives (represented in the Bunderverband Deutscher Banken, BdB) were in favor of a unified model outside the Bundesbank. For the United Kingdom, in contrast, he finds no evidence of explicit views expressed by the market actors at the time of the reforms. The Wallis Commission in Australia also consulted with the financial sector on the reforms of the supervisory framework (Commonwealth of Australia, 1996). In this section we will analyze the market view on supervision architecture and regulatory governance in the case of Italy. The analysis is based on a survey conducted among Italian financial businessmen regarding the supervisory structure and its governance. As such it is one of the first attempts to map the views, preferences and beliefs of the sector in a systematic way, and can provide us with a number of additional insights into the dynamics of the evolving debate regarding supervisory structures and their governance. The Italian situation is particularly interesting, with a bank-based financial system, which has gone through a rapid consolidation in recent years and which is governed by a highly decentralized supervisory model, with five authorities. This model was confirmed by the Italian Parliament in December 2005, but more recently the Center-Left Government started discussing a reform aimed at introducing a twin-peak regime and revisiting the governance model.25 Thus, we are observing a consolidation process in the markets which will perhaps be accompanied by a consolidation in the supervisory architecture. We wonder if in a more concentrated financial industry the market participants have clear preferences on the level of the supervisory consolidation and on the degree of independence and accountability of the supervisors. The identification of the market view can be useful to analyze the choices of the policymakers, in order to test the chain between the financial structure, the market view and the political preferences. 4.1. Italy’s financial system structure The Italian financial industry is a typical bank-based system. We acknowledge that often an arbitrary judgement is made to decide whether a country’s financial industry is bank-based or market-based. Among the many indicators of the financial structure that have been proposed in the literature,26 we use the ratio of the market capitalization of stocks to the gross domestic product. While this measure is intuitively simple and appealing, it remains an imperfect benchmark. However this ratio is sufficient to show that Italy still has underdeveloped securities markets. In the overall country sample, Italy ranks 30th of 88, and among the 24 advanced OECD countries, Italy ranks 16th. This international comparison confirms that the Italian stock market is still smaller than that of the other advanced countries, and that firms – particularly small and medium sized enterprises – have to depend heavily on bank credit.27 Looking at the country figures alone, banking sector assets accounted for 66.5% of the financial system’s total assets at the end of June 2005. In addition, banks control a substantial share of the asset

25 The twin peak model was first discussed by Taylor (1995). The model groups supervision of market behavior of all segments of the financial system in one peak, and conduct of business supervision in another. Thus far the model has only been adopted in Australia and the Netherlands. 26 See among others Beck et al. (2000) and Levine (2002). 27 Draghi (2006b), Cardia (2006).

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management industry—the second most important class of financial institutions with 16% of total assets—and the insurance sector, the third class with 12%.28 The pervasive role of the banks is also reflected in the growing concern of the central bank, which drew attention to the need to ensure that asset management companies were independent of the banking and insurance groups which control them and distribute their products.29 The degree of concentration of the banking industry has been increasing in recent years. Looking at the total value of deposits held by the five major banks, Italy ranks 64 out of 80 in the country sample, and 17th among the 21 OECD countries. However, the number of banks declined from 970 in 1995 to 787 in 2004,30 the six largest banks represent 55% of total assets at the end of 2004.31 In 2006 the first and third largest banks merged, building up the biggest Italian bank: Intesa SanPaolo. The consolidation process is likely to continue: in February 2007 the Governor of the Banca d’Italia claimed that “there is still room for mergers and acquisitions able to create synergies.”32 4.2. Supervisory framework The supervisory framework is a multi-authority model, built around five institutions. The central bank (Banca d’Italia) is the supervisor of the banking system and, with a view to preserving financial stability, is also responsible for supervising the asset management industry, as well as other relevant financial markets, such as wholesale markets for government securities and interbank markets. Furthermore – until the recent law No. 262 of December 2005 – the central bank was the main authority in charge of enforcing the antitrust law. The central bank was by law assigned at least two goals: maintaining financial stability and enforcing the antitrust law. The Italian Companies and Stock Exchange Commission (CONSOB) regulates and supervises the Italian securities markets, while the insurance market is supervised by the Insurance Authority (ISVAP). Pension Funds are supervised by the Pension Fund Authority (COVIP). Finally, the Italian Foreign Exchange Office (UIC) is responsible for anti-money laundering and combating terrorist financing.33 From a theoretical point of view, the Italian regime represents a striking example of the so-called central bank fragmentation effect.34 The number of supervisors is directly related to the central bank involvement is supervision itself, reducing the degree of supervisory consolidation. The Italian Parliament, notwithstanding a declaration in favor of supervision by objectives—see below on this type of regime—confirmed the multi-authority regime with the above mentioned law No. 262 of December 2005 (New Law on Savings). The same law was designed to reform the governance of the central bank in a number of crucial areas. The law moved the responsibility for regulating anticompetitive behavior from the central bank to the Antitrust Authority, with shared responsibilities of the two institutions for bank mergers and acquisitions. The law defined five principles – reaffirmation of central bank autonomy, transfer of central bank ownership to public entities, enhanced collegiality, increased reporting requirements, changes to the mandate of the Governor and the other members of the Directorate – with key provisions to be spelled out in the amendments of the central bank statute.35 The role of a government committee – The Inter-Ministerial Committee on Credit and Savings – in supervision makes it difficult to evaluate the real degree of central bank independence in the supervisory area.36

28

International Monetary Fund (2006). Draghi (2007). European Central Bank (2005). 31 International Monetary Fund (2006). 32 Draghi (2007). 33 International Monetary Fund (2006). 34 Masciandaro (2006). 35 International Monetary Fund (2006), Draghi (2006a). 36 International Monetary Fund (2006). In July 2007 the Anti-Money Laundering proposed a revision of the legislation, which transformed the UIC in the Financial Intelligence Unit, as autonomous department of the Bank of Italy. The proposal became law in November 2007, and the reform will be implement in January 2008. 29 30

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In February 2006 the center-left government proposed a twin-peak supervisory model, or supervision by objectives.37 The twin-peak model states that all intermediaries and markets be supervised by two authorities, with each single supervisor being responsible for one goal of regulation. The Banca d’Italia would be in charge of financial stability, while CONSOB would be responsible for transparency and conduct of business. Both agencies supported the view that supervision by objectives is necessary.38 As part of the reforms, the Inter-Ministerial Committee on Credit and Savings would be eliminated and replaced by a Financial Stability Committee, with three members: the Minister of Treasury (Chairperson), the Governor of the Banca d’Italia, and the President of CONSOB. The Financial Stability Committee would promote the exchange of information, the coordination between the two supervisory agencies, as well as the cooperation between national and international supervisors. Finally, the government proposal defined common rules on the accountability of the two agencies towards the Parliament and its Commissions. 4.3. The market view: the 2006 survey In October–November 2006 a survey, prepared by the authors of this paper, was carried out by the Asset Management Industry (AMI) Association amongst 230 CEOs of the AMI firms. Italy currently has 171 AMI firms; their shareholders are Italian banks (82%), Italian non-bank financial firms (12%), and foreign financial and banking institutions (6%). The AMI managers are highly representative of the Italian financial community. As noted above, the asset management industry is the second largest segment of the financial sector, but more importantly, the AMI firms are mainly controlled by the domestic banks. The answers to the questionnaires (68 respondents, 30% of the overall CEO population) offer an original picture of the market view on the key features of the supervisory architecture. In addition to the aim of increasing our understanding of the market view, specific goals of the survey included the identification of the market preferences on the actual and optimal level of key features of the supervisory setting (efficiency, neutrality, staff saving, responsibility) and governance (independence and accountability), as well as the market’s views on the political feasibility of their reform. 4.3.1. Present structure The first part of the questionnaire surveys the views on the present regime. Questions 1–8 inquire about the respondents’ views on the general features of the supervisory architecture such as the risks of supervisory inefficiency, lack of neutrality, staff surplus, and low responsibility due to the multitude of agencies. Of the respondents, 80% estimated that the risk of supervisory inefficiency is high (more than 50%) in the present institutional setting. The risk of lack of regulatory neutrality is considered high by 75% of the respondents. For 84% of the managers, the staff surplus risk is high, while 59% of them think that the risk of low responsibility is high. Thus, it appears that the market’s appreciation of the overall efficiency of the multi-authority system is low. This view is confirmed by the fact that only 40% of the respondents consider the current regime as effective. 4.3.2. Governance of the present structure Questions 9–14 deal with views on the governance—independence and accountability—of the two main supervisory authorities: Banca d’Italia and CONSOB. The questions start from the assumption that the governance framework has to be designed in such a way that management of the agencies is free from any form of “capture”. The risks of supervisory capture can be classified in three categories: “political capture,” “industry capture,” and “self-interest capture.”39 Thus, independence from politicians (political independence) and the supervised industry (industry independence) can be considered good practice.40 Finally, there is always the risk that a supervisor pursues his/her self interest,

37 38 39 40

Di Giorgio and Di Noia (2007). Cardia (2005), Draghi (2006a). See Masciandaro et al. (2007). ¨ Quintyn and Taylor (2003, 2007), and Hupkes et al. (2005).

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which may not be consistent with the social welfare. Hence, there must be transparent reporting procedures on the supervisor’s activities, as well as rules on staff integrity, to avoid self bureaucrat capture. Accountability and transparency provide the society with assurances that supervision is not manipulated.41 For 45% of the Italian financial CEOs, political independence of the Banca d’ Italia is high (more than 50%), while almost the same percentage of respondents (43%) also consider industry independence high. In contrast, accountability is high in the eyes of only 9% of the respondents. The CONSOB is highly politically independent and industry independent—respectively for 27% and 46% of the responders. The level of accountability of CONSOB is considered high by only 8%. 4.3.3. Preferred supervisory model The second part of the questionnaire deals with views on reforms. The aim of questions 15–28 is to discern if there exists an ideal supervisory setting in the minds of the market participants. The shortcomings of the multi-authority model become evident when analyzing the market preferences with regard to a possible supervision consolidation. In the eyes of the respondents, a reform of the supervisory setting should produce a high (more than 50%) reduction in the various sources of inefficiencies. Among the respondents, 36% look for a significant reduction in the risk of supervisory inefficiency. The need for a reduction in the risk for a lack of regulatory neutrality is considered high for 47% of the respondents. In 45% of the cases, the managers think that the risk the staff surplus should be diminished, and a similar share of respondents favor a reduction in the risk of low responsibility. While an overall reform is urgent for 79% of the respondents, 49% of them express a preference for the twin-peak model, while the other 51% are in favor of a single supervisor. The survey does not document any particular “home bias” preference: exactly 50% of the CEOs think that a national supervisor is better (as opposed to a supervisor at the European level), and 60% prefer national accountability procedures. Regarding the optimal governance rules for supervisors, the financial professionals are in favor of more political independence (74%), more industry independence (72%), but also more accountability (90%). Among the respondents, 54% is a favor or mixed financing rule—a combination of public funds and fees from the supervised intermediaries. What is clear from this survey is that the Italian market view expresses a preference for supervisory consolidation. 4.3.4. Belief in the feasibility of the reforms The final set of questions (29–42) seeks to clarify the market beliefs in the feasibility of a reform. The purpose is to evaluate the alignment between market preferences and the expected government choice. In general, implementing supervisory reforms is seen as a sign of progress, and respondents see a relatively high probability (more than 50%) that a reform will indeed lead to a reduction in the different sources of inefficiencies currently experienced. Among the respondents 68% consider a reduction of the risk for supervisory inefficiency likely. A reduction in the risk of a lack of regulatory neutrality is estimated as likely by 65% of the respondents. 45% of the managers think that it will also lead to a reduction in the staff surplus risk, and 50% of them claim that the risk for low responsibility will be reduced. The financial CEOs think that the politicians prefer to establish accountability rules rather than independence procedures. In fact a reform of the supervisory governance is likely to produce higher political independence (41%), higher industry independence (47%), but mainly higher accountability (57%). However, 86% of the respondents think that the probability of a supervisory reform by the end of the legislation (2011) is equal or less than 50%. The conservativeness of the politicians can be explained in different ways. The government can be in general conservative (28%), or sensitive to the opposition of the supervisors (26%), their unions (57%), or their boards of directors (61%). Thus, the policymakers’ expected behavior seems to be only weakly consistent with the market wishes. However these answers are not sufficient to disentangle the true nature – HH or GH – of the Italian policymaker. What we can conclude, though, from this experiment is that the operators in the Italian markets are: (i) fairly dissatisfied with the current supervisory model, although they like the degree of polit-

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ical and industry independence of the main regulators—Banca d’Italia and CONSOB—but have some doubts about the low degrees of accountability towards their main stakeholders; (ii) overwhelmingly in favor of a more consolidated model, although there seems to be no outspoken majority for a unified model. The new model should be independent from government and industry, but respondents are more concerned with addressing the current accountability deficit; and (iii) reluctant to think that the expected behavior and views of the policymakers will be aligned with theirs. To the extent that parallels can be drawn between these results and worldwide trends, it is worth noting that market participants in Italy are of the view that accountability arrangements are currently weak and should be strengthened significantly, and that they think that politicians are of the same view. This is consistent with worldwide trends, as analyzed in Quintyn, Ramirez, and Taylor (2007), and Masciandaro et al. (2007), which show that reformed supervisory agencies have stronger accountability arrangements than their predecessors, and in particular than the central banks. So the focus on accountability is certainly growing. However let us stress again that the preferences of the market operators can be different from the social optimal ones. According to the GHV, the financial industry aims to extract rents from supervision, in order to serve its specific interest. The CEOs are queried about regulatory efficiency, but we do not know what their benchmark is. That is, when 80% estimate that the risk of supervisory inefficiency is high, we do not know what they mean by inefficiency and how they estimate the risk of inefficiency. In general we do not know how much the CEOs are hoping regulators act in the public interest and how much they hope regulators act in the interest of the CEOs’ industries (or firms). 5. Conclusions The current worldwide wave of reforms in supervisory architectures leaves the interested bystander with a great number of questions regarding the true determinants of, and motivations behind, these changes. These questions are all the more justified because the emerging institutional structures are certainly not homogeneous across countries. Trial and error seems to prevail to some extent. Thus far, academic discussions of the emerging supervisory architectures have been dominated by purely economic views: supervisory structures are being revised because of the blurring boundaries among financial institutions and activities, and the formation of big conglomerates. However, judging from the multiplicity of reform outcomes and politicians’ revealed preferences, the natural question which emerges is: to what extent is the changing nature of the markets really being taken into account? And, related to that, to what extent have policymakers been listening to the views of the markets with respect to the desirable supervisory structure? An answer to these questions requires a political economy approach. Indeed, financial supervisory reform is a political process which involves many stakeholders: the political class, the central bank, the supervised entities, as well as the customers of the financial services. So the all-encompassing question is: which considerations and views prevail in the end in the decision-making process, and to what extent are the decision-makers taking into account the views of these different classes of stakeholders when deciding on a reform of the supervisory structures. This paper tries to answer some of these questions by looking specifically at the impact of the market factor on the decision-making process. More specifically, it first develops a model to analyze to what extent policymakers are taking into account the features of the market structure. Secondly, it reports on the results of a survey among Italian market operators on their views on the efficiency of the current supervisory structure, and on the optimal structure—both in terms of architecture and governance. To answer the first question, the paper starts from two views on the policymaker—the helping hand and the grabbing hand view—to find out empirically how market views are being taken into account. Evidence seems to lean towards the grabbing hand view, considering the degree of banking concentration a proxy of the capture risk and presuming the market demonstrates a preference for consolidation of supervisory powers. The survey sheds interesting light on the Italian case—a strong desire for supervisory consolidation with the aim of making the supervisory process more efficient, and a strengthening of governance arrangements through more accountability. The survey also shows that markets believe that the reform

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views of the politicians are not fully aligned with theirs. However, these findings do not allow us to detect the true nature of the Italian policymaker (HH versus GH). While the results of this paper are encouraging, further research is warranted. More specifically, the analysis on the determinants of supervisory structures in Masciandaro (2006) and this paper needs to be combined with the research presented in Masciandaro et al. (2007) on the determinants of governance arrangements in supervisory agencies. Both shed light on one aspect, but it would be interesting to find out to what extent these two aspects—supervisory architecture and governance arrangements—are two sides of the same coin. Why do politicians in one country allow the central bank to be the single regulator, and why are they inclined in other countries to take supervision out of the central bank and put it in a newly established unified supervisor? Market trends could be one factor in the decision, as this paper shows. However, other elements might be at play as well, such as the desire to have more say in the agency (and thus to take the responsibility away from the independent central bank). Thus, the government’s helping or grabbing hand can possibly leave fingerprints all over the new structure. Acknowledgements ˇ ak, ´ Lucia Dalla Pellegrina, Burkhard The authors would like to thank Michael Taylor, Martin Cih Drees and Caryl McNeilly, as well as two anonymous referees, for useful suggestions and discussions. Rosaria Pansini provided excellent research assistance. All remaining errors are the authors’. Additional materials and supplementary tables related to this paper are available on the NAJEF web site at: http://www.sciencedirect.com/science/journal/10629408. Appendix A. Supplementary data Supplementary data associated with this article can be found, in the online version, at doi:10.1016/j.najef.2008.02.002. References Abrams, R. K., & Taylor, M. W. (2002). Assessing the case for unified sector supervision (FMG Special Papers, No. 134). London: Financial Markets Group, London School of Economics. Agence France Press. (2006, September 29). Polish ex-Finance Minister named Head of Finance Sector Super-Commission. Alesina, A., & Tabellini, G. (2003). Bureaucrats or politicians? Part II: Multiple Policy Task (Discussion Paper, No. 2009), Massachusetts: Harvard Institute of Economic Research, Harvard University). Arnone, M., & Gambino, A. (2007). Architectures of supervisory authorities and banking supervision. In D. Masciandaro & M. Quintyn (Eds.), Designing financial supervision institutions: Independence, accountability and governance. Cheltenham, United Kingdom; Northampton, Massachusettts: Edward Elgar. Associated Press Newswires. (2006, October 3). The Head of Poland’s Central Bank said Tuesday that the bank is suffering the “most extreme” attach on its independence since communism fell in 1989. Barth, J., Caprio, G., & Levine, R. (2004). Bank regulation and supervision: What works best? Journal of Financial Intermediation, 13(April), 205–248. ¨ ¸ -Kunt, A., & Levine, R. (2000). A New database on financial development and structure. World Bank Economic Beck, T., Demirguc Review, 14, 597–605 [Data updated to 2007 at http://econ.worldbank.org] Bezuidenhout, A. (2004). The South African case. In Jeffrey. Carmichael, Alexander. Fleming, & David. Llewellyn (Eds.), Aligning financial supervisory structures with country needs. Washington: World Bank. Briault, C. (1999). The Rationale for a Single National Financial Services Regulator. Financial Services Authority Occasional Paper, No 2. Capie, F. (2007). Some historical perspective on financial regulation. In D. G. Mayes & G. E. Wood (Eds.), The structure of financial regulation (pp. 43–65). London and New York: Routledge. Cardia, L. (2005, March 31). Annual Report 2004. CONSOB, Rome. Cardia, L. (2006, March 31). Annual Report 2005, CONSOB, Rome. ˇ ak, ´ M., & Podpiera, R. (2007). Experience with integrated supervisors: Governance and quality of supervision. In Donato. Cih Masciandaro & Marc. Quintyn (Eds.), Designing financial supervision institutions: Independence, accountability and governance. Cheltenham, United Kingdom; Northampton, Massachussetts: Edward Elgar. Commonwealth of Australia. (1996). Financial System Inquiry Interim Report, Wallis Commission. Camberra: Australian Government Publishing Service. Davis, H. (2004). Integrated regulation in the United Kingdom and the lessons for others. In Jeffrey. Carmichael, Alexander. Fleming, & David. Llewellyn (Eds.), Aligning financial supervisory structures with country needs. Washington: World Bank. De Luna Martinez, J., & Rose, T. A. (2003). International Survey of Integrated Financial Sector Supervision (Policy Research Working Paper Series, No. 3096). Washington: World Bank.

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