Do Regulations Affect Banking Performance? Government Governance May Matter

I. INTRODUCTION Studies of optimal financial systems have recently attracted wide attention. One of the major issues is whether the authority should allow commercial banks (hereafter, "banks") to engage in financial-related and other non-financial activities, where the former are made up of securities, insurance, and real estate, and the latter comprise a mix of banking and commerce. Those who favor limiting commercial banks to merely "traditional" deposit taking and loan making argue that inherent conflicts of interest arise when banks engage in the above financial and non-financial activities. Expanding the array of permissible activities, they may provide greater opportunities for moral hazard, which in turn may distort banks' investment decisions, especially when they operate within a deposit insurance system (Boyd et al., 1998). Those who advocate substantial freedom with respect to commercial banking activities alternatively argue that "universal" banking creates greater diversity, thereby augmenting the profits of banks. (1) Furthermore, these proponents of the lifting of restrictions suggest that the often-claimed conflict of interest does not exist when banks engage in securities. Krosner and Rajan (1994) and Puri (1996) share similar views. Kwan (1997) states that because of a low correlation between banks and securities, a bank should be able to diversify its risk by engaging in security activities. White (1986) studies the securities activities of national banks before the Glass-Steagall Act and finds that the mean and variance of the return to securities affiliates were higher than commercial banks, and that their return correlation was close to zero. Along the same lines, Barth et al. (1998) indicate that in countries in which banks face restrictions vis-a-vis engaging in securities, the likelihood of a banking crisis is greater. Santomero and Babbel (2001) recently reported that a bank's selling of insurance products can substantially reduce its costs. (2) Some opponents to lifting the firewall between banks and securities make the claim that doing so may increase banking risks. Boyd et al. (1993) find that simulations of U.S. bank holding companies merging with life insurance and property/casualty insurance firms may reduce risks, but that mergers with security firms would likely increase risks. Surveying over sixty countries on the three financial-related activities (securities, insurance, and real estate) and one non-financial activity (a mix of banking and commerce) that banks are allowed to engage in, Barth et al. (2000) score each activity from 1 to 4, with a higher number denoting tighter restrictions. They employ the average of 1990-1995 bank data across about 60 countries to investigate the impact of these restrictions on financial (bank and securities) development and industrial competition. They do not, however, find a reliable statistical relationship between regulatory restrictions on financial development and industrial competition. Barth et al. (1998, 2002) also show that countries with more restrictive regulations on average have a larger net interest margin (NIM). This article investigates how government governance (hereafter, governance) affects the impacts of the restrictions on bank performances. This article is in a manner similar to that of Barth et al. (2000), but focuses on the role of governance. The authors provide two conflicting arguments regarding how good governance affects the impacts of the restrictions. The first is the restriction-enhancing hypothesis. That is, when government imposes the restrictions on bank activities, good governance makes this restriction effectively implemented. As a result, restrictive effects are further enhanced. The authors next claim that there is a facility-supporting hypothesis, which argues that a good government will provide a good supporting environment to compensate its restrictions on banks' activities. …