# **IV. Improving Market Discipline**

Regardless of how well market discipline works in developing countries, available evidence suggests that an approach based on official supervision has no significant impact on financial sector development, on the likelihood that the financial system would not be affected by crises, or on the access to credit by firms (Barth, Caprio, and Levine, 2003; and Beck, Demirguc-Kunt and Levine, 2003). Indeed, these studies have suggested that except in environments with well-developed political checks and balances and a highly independent media, improving supervisory powers actually had a negative impact on these variables. Only in extremely advanced institutional settings, with highly developed checks and balances and media independence were broader supervisory powers linked with more positive outcomes.

Many have posited that supervision can only work if the supervisor is highly independent. Empirical evidence on the importance of _de jure_ independence within the government (captured by the ability of administration to remove the supervisor unilaterally) and of independence from the industry being regulated (measured by the extent to which supervisors were protected, at least on paper, from bearing the expense of civil lawsuits and from criminal prosecution for doing their job) both are quite mixed. We suspect that it is not the case that these factors do not matter but rather that it is difficult to capture true independence especially in the former sense from what is written on paper. Even countries in which the _de jure_ independence of the bank supervisor is high, it is plausible that the _de facto_ independence is low where a relatively small number of economic groups or families control a large share of the economy. In these cases, the press also might be captured or even directly controlled by the same narrow group of interests.<sup>20</sup> To be sure, in such environments, markets may not function as well as they might in economies with more arms-length relationships, but they still appear to be capable of having some impact in monitoring banks. Still, efforts should continue both to better understand the institutional prerequisites for effective bank supervision and to advance the cause of institutional development in these areas. However, given that evidence indicates that market discipline can be effective, then it also makes sense for authorities to focus on how to make it work even better.

Instead, much regulatory attention appears to the influenced by the debate regulatory choices in developed countries, where the emphasis is very much been put on bank capital and on requiring supervisors to take prompt corrective actions in the event of banking distress. Table 5 compares indicators of bank regulation and supervision from the first World Bank survey, with most observations from 1998 or 1999, and the second survey, which was taken in early 2003. Focusing on the original 107 countries responding in the first survey, this table shows the responses grouped by countries at different income levels.

> 20  In fact, one of the authors of this paper visited a country in which a family controlling one of the most important domestically-owned banks and a number of holding companies also had a family member as head of bank supervision. This by the way was in a situation in which the limit on family control of a bank was only 5% of total equity.

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