What drives financial reforms?

After the Global Crisis, many countries changed their financial supervisory architecture. In particular, many increased their central banks’ involvement in financial supervision. This has led observers to argue that financial crises are an important driver of reforms in the financial supervision settings – despite the fact that the evidence linking institutional features and supervisory effectiveness remained ambiguous (Barth et al. 2002, Čihák and Podpiera 2007, Eichengreen and Dincer 2011).

Reforms in the architecture of financial supervisory authorities

The creation of unified supervisory authorities independent from the central bank during the 1990s and early 2000s was generally associated with reputational failures of many central banks during banking crises (Masciandaro and Quintyn 2009). Yet, following the Global Crisis, fourteen countries actually increased their degree of central bank involvement in financial supervision, creating a sort of ‘great reversal’ towards prudential supervision in the hands of central banks.

The US legislature passed the Dodd-Frank Act in 2010, rethinking the role of the Fed in reshaping the financial supervision. Even if during the discussion of the bill US lawmakers debated the possibility of restricting some of the Fed’s regulatory powers – as well as increasing the political control over the central bank – the Dodd-Frank Act actually ended up increasing the responsibilities of the Fed as prudential supervisor. In Europe, in 2012 the heads of states and governments of the Eurozone started a process to establish the European Single Supervisory Mechanism (SSM). It entered into operation in November 2014 and has assigned banking supervision to the ECB together with the national supervisory authorities of the participating member states.

Concerning individual EU members, with its new Banking Act of 2011, the German government dismantled its unified financial supervisor (BAFIN) in favour of the Bundesbank, which is now the main banking supervisor. In 2013, the UK government put the key prudential functions of the Financial Services Authority (FSA) within the purview of the Bank of England. In 2010, the Irish Financial Services Regulatory Authority was legally merged with the central bank. Furthermore, an analysis of the reforms undertaken in Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Poland, and Slovakia reveals that the trend towards supervisory consolidation has not resulted in smaller central bank involvement.

This evolution in supervisory architecture towards more central bank involvement is not only an EU trend. In 2013, Russia and Qatar also unified the supervisory structure of financial services in the hands of their central banks. Figure 1 depicts the trend towards a more unified supervision in the hands of central banks in a sample of 100 countries between 1996 and 2013, where higher central bank involvement corresponds to darker colours.

Figure 1. Evolution of unified supervision inside the central bank (1996-2013)

Note: The figure presents the evolution of the E-CBFA index of central bank involvement in supervision constructed in our paper. Darker colours correspond to higher involvement.  

What triggers such reforms?

In order to answer this question, we created a new dataset containing information on who supervises the financial sector including banking, insurance, and financial markets in a large sample of 100 countries during the period from 1996 to 2013. We identified the full set of reforms implemented in supervisory architecture in our sample of countries and developed a new index of concentration of supervisory power in the hands of the central bank.

Our analysis points to two main drivers for these reforms.

• First, we find that financial crises significantly increase the probability that a country reforms its supervisory structure.

Thus, in line with popular belief, experiencing a systemic banking crisis in the two years prior to a reform increases the probability that countries change their supervisory architecture.

• Second, we highlight an equally robust– and more original – ‘bandwagon’ effect. In fact, we show that the politicians are more likely to undertake reforms when their peers do so.

We construct four proxies for this effect. The first measure of bandwagon effects, called ‘same E-CBFA index (world)’ indicates the number of countries all around the world that are characterised by the same financial supervision architecture as a given country in a given year. This variable can be interpreted as follows. If there exist any sort of bandwagon effects in the architecture of financial sector supervision, the probability that a country undertakes a reform in a certain year is negatively related to the number of countries that are currently adopting the same supervisory architecture as it (same E-CBFA). To put it differently, when the supervisory system of the country is the same in many other countries, it is less likely to implement a reform. The more fashionable a supervisory architecture is, the less interested a country will be in implementing a reform to modify it. Similarly, the variable ‘same E-CBFA index (continent)’ looks at the number of countries on the same continent that are characterised by the same financial supervision as a certain country in a given year.

If these two variables provide information on the number of countries that adopt the same financial supervisory architecture in a certain year, the other two variables we construct provide an indication for the ‘popularity’ of undertaking certain reforms. More specifically, the variable ‘reforms in ECBFA (world)’, measures the number of countries that are undertaking a supervisory reform (that modifies E-CBFA) all around the world in a given year. If reforms in financial supervision architecture are fashionable in a certain year, this should make it more likely for a country to reform its supervisory architecture as well. Similarly, we define the variable ‘reforms in ECBFA (continent)’, which indicates the number of countries that are undertaking a supervisory reform in some year and are located in the same continent as the country. Thus, given the four different measures that capture a bandwagon effect, we expect a negative relationship between the probability of a reform and the first two variables, and a positive correlation between the likelihood of a reform and the last two variables.

Results

The bandwagon effects variables are negatively correlated to the E-CBFA reform dummy and strongly significant across all specifications.

• Thus, countries seem more inclined to change their supervisory architecture if their institutional setting is less used among their peers.

At the same time, the bandwagon variables are positively correlated with the probability of a supervisory reform.

• This implies that more reforms will be undertaken in periods in which other countries are also reorganising their supervisory architecture.

Therefore, our results show an interesting fashion effect among politicians. The politicians seem more inclined to change their supervisory architecture if their institutional setting is less used among their peers. At the same time, the bandwagon variables are positively correlated with the probability of a supervisory reform. This implies that more reforms will be undertaken in periods in which other countries are also reorganising their supervisory architecture.

The bandwagon effect produced a positive spillover on the role of the central bankers as supervisors. It is worth noting that this effect is completely absent from any traditional explanation of the central banking designing. Our results support the view that the economics of the central bank setting has to be even more integrated with political economy considerations (Alesina and Tabellini 2007, Alesina and Stella 2010).

References

Alesina A and G Tabellini (2007), “Bureaucrats or Politicians? Part I: A Single Policy Task”, The American Economic Review, 97, 169-179.

Alesina, A and A Stella (2010), “The politics of monetary policy”, in Friedman, B M and M. Woodford (Eds.), Handbook of Monetary Economics, Volume 3 , Chapter 18, pp. 1001–1054. Elsevier.

Barth, J R, D E M Nolle, T Phumiwasana, G and Yago (2002), “A Cross Country Analysis of the Bank Supervisory Framework and Bank Performance”, Financial Markets, Institutions & Instruments, Vol. 12, No. 2, pp. 67–120.

Čihák, M and R Podpiera (2007), “Experience with Integrated Supervisors: Governance and Quality of Supervision,” ed. by Masciandaro, D. and Quintyn, M., in Designing Financial Supervision Institutions: Independence, Accountability and Governance, pp. 309–341 (Cheltenham, U. K.: Edward Elgar).

Eichengreen, B and N Dincer (2011), “Who Should Supervise? The Structure of Bank Supervision and the Performance of the Financial System”, NBER Working Paper, No. 17401, National Bureau of Economic Research.

Masciandaro, D and M Quintyn (2009), “Reforming financial supervision and the role of central banks: a review of global trends, causes and effects (1998-2008)”, CEPR Policy Insight 30, 1–11.

Masciandaro, D and D Romelli (2015), “Central Bankers as Supervisors: Do Crises Matter?”, Baffi Carefin Center, Bocconi University, Research Paper Series, forthcoming.

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Authors: Donato Masciandaro is a Professor of Economics, and Chair in Economics of Financial Regulation, Bocconi University. Davide Romelli is a PhD candidate in Economics, ESSEC Business School and THEMA-University of Cergy-Pontoise.