metadata: authors: 0: author: Kane, Edward J.
1: author: DEC
count: World
docna: 0: docna: Difficulties of transferring risk-based
            capital requirements to developing countries
docty: Policy Research Working Paper
subtopic: State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Financial Crisis Management & Restructuring,Financial Regulation & Supervision,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development,Environment,Macroeconomics and Economic Growth,Law and Development
abstracts: cdata!: In principle, financial regulation seeks
            to remedy recognized deficiencies in a nation's
            economic, political, and bureaucratic incentive structures.
            But the social urgency of particular financial policy
            problems differ according to a country's stage of
            development.  Regulatory strategies that make sense for
            industrial countries are unlikely to work the same way in
            developing countries.  The author examines opportunities for
            transferring the framework of risk-based capital
            requirements negotiated by the G-10 countries under the
            auspices of the Bank for International Settlements in Basle.
            He finds that an unchanged transfer of the Basle framework
            to developing countries is economically inappropriate and
            politically infeasible.  And its voluntary adapation is
            difficult because the long-run economic appropriateness of
            the Basle framework of solvency regulations directly opposes
            their short-run political embraceability. The author
            believes that what most urgently needs to be transferred to
            developing countries are elements of supervisory technology:
            methods of information collection and management, legal
            processes for prompt and equitable default resolution, and
            mechanisms for controlling the incentive conflicts that lead
            bankers and government supervisors to resist the healthy
            exit or recapitalization of damaged institutions.  As a
            first step, the author recommends that the World Bank and
            the Bank for International Settlements promote economically
            beneficial reforms in information collection and management,
            reforms that do not preclude flexibility in current
            prudential standards in individual countries.
repnme: repnme: Difficulties of transferring risk-based
            capital requirements to developing countries
display_title: Difficulties of transferring
            risk-based capital requirements to developing countries
listing_relative_url: /research/1994/01/698702/difficulties-transferring-risk-based-capital-requirements-developing-countries
topicv3: Education, Skills Development and Labor
            Market m1326135 1484,State Owned Enterprises m1326323 721,Credit Scoring m1505077 3882,Credit Risk m1505083 3885,Trade Guarantees m1505111 3906
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development,Environment,Macroeconomics and Economic Growth,Law and Development
origu: UNKNOWN
no_of_pages: 33
model_extractions: I POLICY RESEARCH WORKING PAPER 1244

# Summary findings

In principle, financial regulation seeks to remedy recognized deficiencies and inefficiencies in a nation's economic, political, and bureaucratic incentive structu:es. But the social urgency of particular financial policy problems differ according to a country's stage of development. Regulatory strategies that make sense for industrial c untries are unlikely to work the same way in developing countries.

Kane examines opportunities for transferring the framework of risk-based capital requirements negotiated by the G-10 countries under the auspices of the Bank for International Settlemerts in Basle. He finds that an unchanged transfer cf the Basle framework to developing countries is economically inappropriate and politically infeasible. And its voluntary adaptation is difficult because the long-run economic appropriateness of thc Basle franiework of solvency regulations directly opposes their short-run political embraceability.

Kane believes that what most urgently need to be transferred to developing countries are elements of supervisory technology: methods of information collection and management, legal processes for prompt and equitable default resolution, and .nechanisms for controlling the incentive conflicts that lead bankers and government supervisors to resist the healthy exit or recapitalization of damaged institutions.

As a first step, Kane recoinmends that the World Bank and the Bank for International Settlements promote economically beneficial reforms in information collection and management, reforms that do not preclude flexibility in current prudential standards in individual countries.

This paper-a product of the Finance and Private Sector Development Division, Policy Research Department-is part of a larger effort in the department to study developing country financial regulations. The study was funded by the Bank's Research Support Budget under the research project "Risk-Weighted Capital Adequacy Requirements: An Application to Developing Country Banks," (RPO 677-41). Copies of the paper are availabie free from the Worli Bank, 1818 H Street NW, Washington, DC 20433. Please contact Paulina Sintim-Aboagyc, room N9-059, extension 38S26 (28 pages). January 1994.

**_The Policy Research Worting Paper Series disseminates ie findings_** _of_ **_work in progress to encourage the exchange ofideas about development iss.s. An objeative ofihe sries is togt; the findings out quickly, even if the presentationsar less thanfully polisbed. The_** _papers carry_ **_the names of the authors_** _and_ **_should_** _be used and cited accordingly._ **_The_** _fsndings, interpretations, and coneinsions_ **_re the ajbors' own and s;i;uld not_** _be attribwed to_ **_ite_** _World Bank its Executive Board of Directors, or any of its_ **_member countries._**

Produced by the Policy Research Dissemination Center
# Difficulties **of** Transferring Risk-Based Capital Requirement to Developing Countries

by Edward J. Kane*
1

# DIFFICULTIES OF TRANSFERRING RISK-BASED CAPITAL REQUIREMENTS TO DEVELOPING COUNTRIES **Edward J.** Kane ,BsonColl

In principle, financial regulation seeks to remedy recognized deficiencies and inefficiencies in a nation's economic, political, and bureaucratic incentive structures. Because the social urgency of particular financial policy problems differs according to a country's state of development, regulatory strategies that make sense for developed countries are unlikely to work in the same ways in various different developing-country contexts.

Keeping this idea in the fo-efront, this paper cxarnines opportunities for transferring the framework of risk-based capital requirements that was negotiated by the G-10 countries under the auspices of the Bank for International Settlements in Basle. The analysis finds that an unadapted transfer of the Basie framework is economically inappropriatEc and politically infeasible. At the same time, voluntary adaptation is difficult because the long-run economic appropriateness and short-run political embracability of hypothetical adaptations in the Basle framework of solvency regulation stand in direct opposition to each other.

The author believes that the elements of supervisory technology that most desperately need to be transferred to developing countries are methods of information collection and management, legal processes for prompt and equitable default resolution, and mechanisms for controlling the incentive conflicts that lead bankers and government supervisors to resist the healthy exit or recapitalization of damaged institutions. As a first step, the paper recommends that the World Bank and Bank for International Settlements (BIS) promote economically beneficial reforns in information collection and management that do not in themselves preclude flexibility in the prudential standards that hold sway in individual countries.

* The author is the James F. Cleary Professor in Finance at Boston College. He wishes to thank the World Bank for financial support and Herb Baer, Gerald Caprio, Asli Demirgu.-Kunt, Robert Ecenbeis, David Scou. Andrew Sheng, Joseph F. Sinkey. Jr., and Dimitri Vitias for valuable comments on an earlier draft
2

# **L. Problems of Adapting the 0.10 Pattern of Solven=y** Regulation **to** Developing Countries

For G-10 countnies, the 1988 Basle agreement served two purposes: prescribing limits on beggar-thy-neighbor opponunities for slackening bank supervision as a means of promoting the export of financial services to other countries and improving the efficiency of prudential bank regulation on a global basis. Obviously, promoting financial-services exports is a relevant issue only for countries whose institutions compete credibly for foreign customers in the global financial marketplace.

The G-10 agreement symbolizes the ostensible disdain that authorities in the financially most-developed nations of the world have for policies that seek to use lax banking regulation as a device for winning financial trade rrom other countries.

However, in developing countries, lax prudential banking regulation serves other sectors and much broader policy purposes (Eisenbeis, 1992). These other interests must be identified anid addressed on a country-by-country basis if leaders of these countries are to be expected to accept outside restraint on their ability to use bank solvency policy to con;rol the amount or distribution of credit.

As a scheme for increasing global regulatory efficiency, the Basle agreement embodies two thrusts. It erects a shared rule-based framework for currently measuring and enforcing individual-bank solvency and it pledges signatory governments to .t. ongrun evolutionary task of improving their bank solvency standards.

The current frarnework prescribes that calculations of bank iisk exposure recognize the effect of various off-balance-sheet positions and requi.es that risk weights be developed to categorize differences in estimated credit risk across broad asset categories. Evolutionary goals envisioned for the system include the incorporation of other types of risk, particularly interest-rate and sectoral credit-concentration risk.

Currently, the Basle framework sets minimum ratios for stockholder equity and total capital, respectively, at four and eight percent of a bank's risk-weighted credit-risk exposure. But the pact's exclusive focus on credit risk and purportedly common standards for measuring bank capital allow considerable leeway for individual countries in how risk, capital, and supervisory standards may be interpreted and implemented (Hall, 1'A90). Although a source of current regulatory enfeeblement, these implementational loopholes are envisioned as agreement-promoting sweeteners meant to ease the transition
3 for individual G-10 countries to common and comprehensive rules and then fade away over time.

Trying to adapt the Basle framework and pledge to the service of developing countries poses a hard dilemma. On the one hand, to establish commensurate levels of safety between banks in G-10 and developing countries, minimum ratios for bank capital would realistically have to be tied to inverse measures of the completeness of a country's financial infrastructure and the perceived s.ability of its financial, macroeconomic, and political environments. On the other hand, to wvin the acceptance of leaders of developing countries, the risk-based framework and evolutionary pledge would have to offer considerable flexibility. In particular, authorities in most of these countries would want to preserve their discretion to relax effective capital standards when their economies or banks became weak.

The political ,.nvironments of most developing countries subordinate bank supervision to monetary-policy goals. Leaders typically piefer to be able to relax supervisory priorities as necessary to serve these larger goals. This preference assigns a low value to year-to-year continuity in bank supervision. Any shoit-run threat to a government's survival, whether from scandal ot adverse macroeconomic events, is apt to persuade its leaders to de-emphasize long-run plans for improving bank supervision.

While policy instability probably narrows with financial development, it represents a universal feature of modem nation states. Even in developed countries, authorities prove all too comfortable with imposing delayed but long-lasting costs on strong banks and general taxpayers to generate quick-developing but transient benefits for targeted sectors. Administrative discretion to downgrade the importance of prudential supervision and i. nstall ad hoc systems for influencing the sectoral allocation of deposit-institution credit has been repeatedly exercised in the U.S. One need look no farther than the Clinton Administration's protriotion of "community development banks" and its efforts to respond stubborn macroeconomic weaknesses by taking steps to help smaU business to deal with the politically convenient scapegoat of a bank-led "credit crunch." It is hard to imagine how the international communir) could exercise enough discipline to make it likely that long-term financial-regulation commitments made by fading or discredited governments would be upheld in the face of strong political
4 counterincentives. Acknowledging the inescapability of systematic political overrides, this paper does not try to establish how the level and structure of bank capital requirements should vary ideally across nations with different financial and macroeconomic milieus. Rather, the paper seeks to clarify the urgency of reshaping the informational infrastructure of financial institutions in developing countries so as to improve and standardize the methods used to measure capital and risk exposure at commercial banks.

The analysis presumes that the difficulty of monitoring and pclicing bank solvency and enforcing a rational exit policy increases as a nation's financial infrastructure becomes more rudimentary and/or more nationalized (Polizatto, 1990; Scott, 1992). In developing and former Socialist countries, the wonh of individual assets and liabilities cannot be tracked with gr -at precision. Poor information systems, extensive govemment ownership, thin finanzial markets, and shortages of supervisory skills make banks especially hard to value Information gaps and the concentrations in export earnings expose stakeholders in developing-country banks to difficult-to-hedge adverse economic shocks. At the same time, the rggulatory and supervisory skills needed to monitor and police bank risk taking are hard for these countries to develop and retain.

These difficulties limit how much the world regulatory community can reasonably expect risk-based capital requirements to achieve in developing countries. They create e need to constrain --rather than piously striving to eliminate-- variation across countries in how to measure risk and capital and in how to deal with weakness in bank capital when it arises. As a first step, the World Bank and BIS can reasonably exert such constraint by designing ard promotirg the transfer of prototype information systems for bank recordkeeping and credit analysis. Its staff must expressly adapt and stratify different information systems for differentiated supervisory use in countries whose financial markets and institutions qualify as logically distinct financial environments.

Recognizing that policy frameworks will never completely converge highlights the advantages of assuring that, within limits that are set inescapably by observational difficulty, bank risk-taking and capital positions are transparent enough in all countries to be monitored and disciplined by stockholders, customers, regulators, ard taxpayers. Implicitly or explicitly, the organization of bank supervision in any country may be divided into two parts. First, regulators establish incentives that seek to encourage banks
5 to hold sufficient capital to support their overall 'oss exposure. Second, the suppliers (i.e., owners) of whatever mix of private and governmental capital each bank actually deploys look for informadon with which to monitor the loss exposure their stake in the bank passes through to them. In developed and developing countries alike, the great ('anger is that taxpayer stakes in explicitly and implicitly nationalized banks remain at least partly hidden from view. Defects in the incentive systems governing public service are supported by blockages in the flcw of information on the quality of job performance. In any country where the private monitoring sector of the financial infrastructure is weak or nonexistent, regulatory performance can be improved by an inflow of skilled resources into independent prvate auditing and credit-rating industrics.

The fact of countercyclical and idiosyncratic fluctuationm in a society's political willingness to enforce restrictions on the deal-making opportunities of its banks calls for lawyers, accountants, and economists to develop information, contracting, and regulatory technologies that can permit capital stndards to be tightened or relaxed over the business cycle in an economically efficient manner. In practice, supcrvisory efforts often offset rather than reLninorce the market pressures that would ordinarily discipline the risks to which bank lending, funding, and other ;)usiness strategies expose various stakeholders. Brock concludes from surveying banking policy in Latin American countries (1992, p. xiii) that "government shielding of banks from the hazards ... and influence of thL free market fosters unsound, crisis-prone banking systems." Government supervisory mechanisms that are intended to assure prompt corrective action from economically insolvent banks cannot be stopped from responding to pol-1cal and macroeconomic pressure. Nevertheless, economic efficiency would be served if governments would commit to fostering unbiased and nonsecretive measurement of private and governmental contributions to bank capital. If infornationally disadvantaged bank stakeholders are to be protected throughc'tt the globe, individual country banks must be monitored and disciplined by reliable parties who can make it difficult for politicians and regulators to renege surreptitiously on their commitment to informational adequacy and transparency.
6

# 1, M **-,nk Capital**

Repetidon of regulatory-policy jargon tends to anesthetize observers to the need to explore nuances in the meaning of the economic concepts that stand at the heart of policy discussions. Each of the four v ords featured in the term "risk-based capital requirements" is conceptually much less straightforward than it appears at first blush.

Everyone agrees that a t .nk's cil position is a measure of net worth: the value of its assets net of appropriate iabilities. However, great differences exist both about huw individual assets and liabilities should be valued and about which of a bank's individual positions and commitments should be itemized and netted against each othcr. Similarly, everyone agrees that ti£k refers to the chance that a bank may encoulnter bad future oatcomes. Good and bad outcomes emerge as the net effect of variation in customer loan default experience, in bank liquidity needs, in relative interest rates, in employee fraud, in operative regulatory and tax frameworks, in the price of foreign exchange, and in other systemic forces. Finan:ial nalysts frequently aisagree about whether the chanck of some bad outcomes is either adequately hedged or small enough to be neglected. Moreover, what is bdd or good may vary with the horizon over which a bank's performance is to be evaluated. Even ex ante, investments that look wonderful in the short run may look disadvantageous in the long run, and vice versa.

in addition, framing the policy task as if it were one of developing a set of reasonable capital _rirats_ adopts a dangerous simplification. Promulgating a set of supervisory standards is only half of the task, in that standards do not of themselves bind regulatee behavior. Supplementary action must be taken to motivate regulators to -- implement and banks to meet-- the balance-sheet targets promulgated standards embody. In practice, only enforcement procedurms can fulfill this additional function. Adequate penalties must be defined and these penalties must be promptly and predictably enforced.

Finally, the operative policy question is **not** whether it is prudent for supervisors to ba bank capital standards on risk. nie desirability of this connection goes without saying. The problem lies in firding a risk-weighting formula that covers all relevant types of risk and balances the costs and benefits the policy generates for regulatees. Conscientious policymakers must recognize that, to balance benefits and costs through time, the risk-weighting framework must be adaptive enough to respond to change in
7 expectations and to evolve with financial technology and the larger<sup>economic</sup> environment.

**Bank** Canital **as** a Financial Stake Being Plaged at Risk by<sup>Less-Prntected Parties</sup> Modem corporate finance views a frum as an aggregate of explicit and implicit contracts that collectively assign various claimants a prospective<sup>"stake" in the cash flows</sup> a firm's assets generate Although individual stakes can be positive<sup>or regative, the</sup> market value of all stakes must sum to the market value of the<sup>assets. A bank's principal</sup> stakeholders include: stockholders; mranagers anrd other emplyces;<sup>established borTowcrs;</sup> depositors; nouideposit creditors; and (through the explicit<sup>or implicit government</sup> guarantees other stakeholders may enjoy) taxpayers.

The value of each stakeholder's claim may be cor.ceived<sup>as the present discoun:ed</sup> value of the returns that claimholder may reasorably project will develop<sup>in the future.</sup> Stakeholders command risk premiums for whatever risks the<sup>market perceives to inhere</sup> in their positions. Hence, the riskier its projected cash flows, the<sup>more severe the</sup> discount rate to which a stakeholder's anticipated returns are<sup>subject.</sup> To asscss a claim's riskiness, it is instructive to array bank stakeholders<sup>in two</sup> related ways: (1) in terms of their ability to force liquidation<sup>and the priority or</sup> "seniority" their claims receive in the event the bank<sup>is liquieated, or (2) in terms of</sup> stakeholders' access to "inside" (i.e., nonpublic) information<sup>about the bank's futi're</sup> prospects. Accountants, economists, regulators, and financial<sup>analysts all interpret a</sup> bank's "capital" to measure the D= assets that a designated group<sup>cf potentially junior or</sup> inside stakeholders stand to lose before future losses begin to reach<sup>senior or outside</sup> stakeholders.

Bank capital is meant to act as a "shock absorber" for claimholders<sup>whose stakes</sup> are positioned up the line in a loss-absorption chair. of financial dominoes. Writing<sup>the</sup> funding contracts that determine where stakeholdcrs stand in<sup>this chain can be likened to</sup> spacing these dominoes. The first few dominoes in the array am typically<sup>placed close</sup> together. These dominoes are apt to wobble whenever the value of<sup>bank earnings or</sup> assets is bumped unfavorably. On the other hand, the last few<sup>dominoes stand fairly far</sup> apart. They are likely to be jarred only by shocks that are truly severe.

In the simplest funding structure, bank capital consists of the value of<sup>every dollar</sup> (or other currency unit) of owner equity that stands in front of depositor claims. Whether
8 they face simple or complicated funding structures, depositors and their guarantors need to defend their hoped-for isolation from piobable loss. This is done efficiently --not by setting high initial capital requirerments-- but by making sure that the stakes of lowerpriority svakeholders are rebuilt promptly whenever they decline in value. This means monitoring the value of lesser-priority stakes and pressuring bank managements emther to rebuild or to sunender thesc posido-s when and as advcrse developments compromise them.

Measuring the sensitivity of insider stakes to the asset and liability writedowns that might be implied by changing conditions '; the operational problem that bank supervisors face under the risk-based capital framework. To address this problem, ;upervisors -nust promote adequacy and transparency in bank record keeping.

For credit policy and loan evaluation, this means installing documentation requirements that mandate establishing adequate provisions for loai. losses and explicit files for each of the traditional five C's of credit analysis: cash-flow projections, collateral, char;.;ter evaluation, vulnerability to changing economic conditions, and borrower capital strength.

Explicit and implicit government guarantees of borrower performance are collateral-like "credit enhancements." Especially in developing countries, it is important to separate the value of formal and conjectural guarantees a bank receives from the standalone value of loans it makes to state-owned enterprises and members of governmentally favored economic sectors.

In any developing country, improving the quality of bank information systems needs to be made a high-ranking objectivc of prudential regulation. In more than a few countries, loan-loss provisioning has been ignored and several of the hypothetical "five C" file folders that constitute appropriate credit files have been left emptv. In these countries, setting a nominai 10-percent or 20-percent capital requirement will do less to stabilize the banlking sector than adopting a conscientious program for building databases -at individual banks that ame capable of enhancing capital mea%urement and enforcement over time. However defici-nt a developing nation's ballpoint-pen and carbo.n-paper information system may be ,t the start, its authorities should be urged to throw off limitations on their capacity for measurrng bank capital and risk exposure and to ensure
9 that their information base and valuation technology<sup>improve over time at a reasonable</sup> speed. **MDrfculties sjf RegCgnizing and** Meaur'ing the **Government's**<sup>Contribution tg</sup><sup>**MUi**</sup> Capital in Developiny Countries Even in G-10 countries, depositors enjoy implicit<sup>and explicit government</sup> gualantees of repayment. Typically, the user<sup>charges that banks pay for these credit</sup> enhance,nents fail to capture the full value<sup>of</sup><sup>**-it**least the implicit or conjectural ponion of</sup> the guarantees they enjoy.

Economic analysis conceives of the capitalized<sup>vae of underpriced government</sup> guarantees as a taxpayer contribution to bvnk<sup>capital (Kane, 1985). For banks in</sup> developing countries, the ratio of government<sup>capital to private capial often equals or</sup> approaches 100 percen'. Sometimes (as in<sup>Eastern. Europe) bank nadonalizadon comes</sup> about as a matter of ideology. In other cases,<sup>it develops informally as formerly priv4e</sup> instituions are left open after they have become<sup>economically insolvent on a stand-alone</sup> basis. The ability of institutions that la^k enterprise-cor.tibuted<sup>net worth to service their</sup> depositors comes from a widespread understanding<sup>that the government has spread a</sup> "safety net" that puts taxpayers' credit in<sup>place of funds provided by the bank's nominal</sup> owners.

Managerial and regulatory incentives differ<sup>greatly between private and</sup> governmer. owned banks. Whether a country's<sup>banks are nationalized de iur or merely</sup> d: facto, the condition of effective government<sup>ownership lessens the prudential benefits</sup> society receives from risk-based capital requirements.<sup>This occurs for two reasons. First,</sup> with respect to risk-taking the interests of top<sup>govemment rmgulators and the least-secured</sup> private stakeholders in a gov:rnment bank tend<sup>to converge rather than diverge. Second,</sup> taxpayers are seldom able to monitor the use<sup>made of their stake in a bank as effecively</sup> as private stockholders and bondholders can.

Whether and how well risk-based capital requirements<sup>nelp taxpayers to mor.i!^r</sup> their stake in a country's banks depends on how<sup>well and 1lOw frequently the information</sup> system measures taxpayer stakes and bank risk<sup>taking for them. Hence, for govemment-</sup> owned and private banks alike, weaknesses<sup>in information and valuation technologies</sup> stand as major obstacles to better prudential regulation.
10

# Itemizat;on Issues

An asset is .nything that produces prospective positive cash flows and a liability is any claim that serves to fund the value of one's asset holdings. A corporation's balance sheet records its assets as positive items and enters liabilities with a negative sign.

Economic concepts of bank capital look to capturc the capitalized value of AU sources and uses of funds. In effect, economists present net worth as an estimate of the stock-market value of owning the firTrn.

In the U.S., the capital concept embodied in accountants' Generally Accepted Accounting Principles (GAAP) employs a more-selective itemization scheme. Except when they are asked to account for the price one corporation pays to purchase control of another, accountants itemize only what they call "tangible" items.

A tangible asset is something that can in principle be bought and sold separately from the particular enterprise which happens to employ it at the moment. An intangible asset is an asset that has value only when it is deployed in combination with other tangible assets (as, e.g., the loyaltv of a firm's customer base) or is a right conferred on the owner by a government (as, e.g., a patent) or other corporation (as, e.g., a leaschold or patent license). Intangible assets include "going-concern values" that allow the collection of intangible assets that a firm manages to earn a higher return in a given enterprise than these assets could earn if they were redeployed to their next-best use.

Elements of the accounting concept of intangible "goodwill" may be recorded in footnotes in the U.S., but goodwill may only be booked into a firm's balance sheet when it is necessary to account for a firm's purchase price. Goodwill is a resieual accounting item that serves to reconcile the GAAP concept of net worth on the date of a corporate acquisition or merger with the economic concept of the market value (i.e., the purchase price) of the corporation. In purchase accounting, GAAP net worth has two components. The first component consists of the liquidation value of the net tangible assets of the target firm. Goodwill is conceived as the additional value the fLrm is able to promise as a going concern. In turn, a firm's going-concern value is presumed to come from having accumulated a skilled staff and favorable reputation and having deployed the firn's assets in products and locations that are mutually adapted to the wants of a loyal customer base.

Accounting goodwill measurcs intangible net worth. It represents the capitalized value of putative sources of valuc that GAAP ordinarily neglects. Goodwill values the
II firm's ability to earn above-market returns on the tangible positions shown in its tangible balance sheet. In principle, financial economists seek to partition a corporation's intangible net worth into three time-related portions:

- a) the value of "identifiable" intangible assets such as a corporate reputation, staff, business locations, and a customer base whose value is built up from wise expenditures made in the ps;

- b) the capitalized value of ongoina. net regulatory subsidies or burdens that flow from existing and projected laws and supervisory practices;

- c) the present value of growth opportunities (PVGO), which varies according to strategic adaptations and innovations that the corporation might make in the fu.

Stock market values or takeover bids that diverge greatly from book values of tangible net worth make U.S. regulators uncomfortable. However, when U.S. regulators choose to give accounting relief to troubled institutions, they typically do so by selectively authorizing these institutions to record the values of specific categories of intangible assets. For example, in 1982 federal regulators authorized beleaguered thrift institutions to take into their balance sheets appraisal-based estimates of the extent to which theL office buildings had appreciated above their book value.

A skeptical attitude toward intangible net worth is embodied in the itemization rules established by the Basle agreement. To the extent that intangible sources of net worth are recognized, such items are classified as "secondary" rather than "primary" capital.

Downplaying intangible net worth is traditional among Western European regulators, who have long preferred that their banks maintain off-balance-sheet sources of strength. But it is doubtful that East European and deve'oping countries can afford to neglect intangible items. The desirability of assuring that intangible positions are valued fairly around the world should lead the World Bank to conduct research aimed at identifying reliable procedures for valuing intangible bank assets in different financial environments.

# Valuzalodn s

In different countries, professional accounting standards boards are free to authorize different valuation principles. For U.S. deposit institutions, GAAP bal.,nce
12 sheets develop item values from their historical =. Items are carried at historical cost except in two cases: (1) when it is decided to reserve against a "reasonably anticipated" loss and (2) when an amonization account is established to reduce an item's book value according to a specified schedule of decline (e.g., to reflect depreciation).

Economists seek to measure an asset's cent xn= and liken attempts to rely on historical-cost measures of bank perforTnance to trying to steer a car by monitoring the car's progress through its rearview mirror. To economists, an asset's value comes not from what was once paid to acquire it, but from its present-day ability to generate future income.

Current values may either be observed or estimated. Current value is treated as indirectly observable whenever the price of identical or closely comparable substitute assets trade in active public markets. However, when comparability to traded assets is imperfect or the observability of some dimensions of the price paid is impaired, appraisers and economists need to check market-based judgments against calculations of the present discounted value (PDV) of reasonable projections of the asset's future returns. In principle, the interest rate employed in the discounting process increases both with the variability of the asset's objective retums and with the shakiness of the subjective assumptions on which projections must be founded. In practice, conscientious analysts experiment with a range of altemative retum projections and discount rates with the aim of developing high and low estimates that may be confidently said to bracket an asset's true PDV. Because the process of making and discounting projections leaves potential room for dishonestly manipulating hypothetical item values, economists regard adjusted market values as a more pmcise and reliable touchstone than PDV.

# Constraining Regulator Arbitrariness

Although constrained to some extent by international agreements, financial regulators in different countries and different regulatory agencies are free to adopt whatever itemization rules and blend of historical-cost and current-value approaches happens to serve their immediate policy purposes. The World Bank or BIS can make these policy choices less inefficient by forging and promulgating market-disciplined standards for capital measurement and risk assessment. The procedures outlined in the following sections ame reproducible, model-based, and designed both to confront and to lessen the data limitations that are known to exist in developing countries.
13 If promulgated for universal use, these procedures need not themselves place a country's policymakers at an impossible disadvantage. This is because the disciplinary use to be made of the resulting measures would still be left to the discretion of local policymakers. Whether authorities in a given country want to enforce high or low ratios of risk-adjusted capital, taxpayers are bound to be exploited if regulators are prevented from challenging weak banks' efforts to overstate their capital strength and understate their risks.

1_1I Confronting the Need for Better7r_orTatoon SysteMS for Measuring Bank Risk Banks are institutions that earn income by servicing the rinancial wants of their customer base. Among customer wants is a desire to transfer risk from themselves financial-services firms. This want is important enough that a major portion of tht t el income earned by most banks consists of rewards they accrue in exchange for relic' .. their customers of "calculated" risks. A bank's ability to earn profits from risk-takin& turns on its managers being able to understand the risks that attach to the deals they accept and to extract a rmasonable return for bearing these risks.

It is either unrealistic or a sign of poor management for bankers to argue that the opportunity-cost value of their institution's capital is essentially unknowable. Whether a bank is evaluating an existing position or a new lending or funding opportunity, its managers must assess and price the associated risk fairly. Good management begins with establish`ng a system that can generate the information needed to track at least the broad magnitude of the corporate accounts that is asked to control. What differs across countries is how reliably a conscientious inside or outside analyst may estimate the distance between upper and lower bounds on reasonable estimates of the value of bank capital (Berger, King, and O'Brien, 1991).

In developing sociedes, economic information and analysis are scarcer than they are in developed countries. Tnis scarcity increases the **expense** of generating upper, lower, and baseline projections of most would-be borrowers' economic prospects and decreases the reliability of whatever projections are made. Differences in the costs of compiling and analyzing relevant information help to explain why corporate reliance on ownership equity and use of financial intermediaries tends to be high in infornation-poor
14 economies, while information-rich societies experience expanding use of patterns of direct finance (Mayer, 1993; DemirgUg-Kunt and Huizenga, 1993).

While acknowledging that dramatic growth has occurred in the ways that a modern bank can expose itself to risk, Corrigan (1992) opines that: ..."almost without exception, the most serious banking problems encountered in recent years have grown out of old-fashioned difficulties with bad loans and excessive concentrations." (pp. 5-6) Except that it has yet to deal with concentration and governmental default risk, the Basle Agreement is based on this presumption. It seeks to align a bank's capital with its exposure to nongovernmental credit risk. A unit risk weight is assigned to the loans a bank makes to businesses and consumers. "Credit conversion factors" are employed to translate off-balance-sheet positions (e.g., debt guarantees and forward commitments) into loan-equivalent investments. In fashioning both the conversion factors and the weights assigned other on-balance-sheet assets, the unit weight assigned to bank loans serves as the linchpin of the risk-evaluation system. Fractional weights or conversion factors of zero, twenty, or fifty percent are assigned to other portfolio pcsitions. Because this approach ignores potentially important variation within each risk class, each factor and weight is best conceived as expressing the extent to which the particular activity suffers on average from default risk.

Default risk is the danger that the money a bank loans out will not be returned with interest as promised. For private and governmental borrowers alike, payment schedules must be established so that borrower performance can be tracked explicitly. Categories of nonperformance for loan contracts range from delays that leave payments in arrears through payments that prove late enough to be classified as formally delinquent to events of de facto default. It is not wise to permit payments to be booked routinely from prepaid interest reserves or open credit lines. This obscures information that in any well-managed bank could play an important role in designating loans for inclusion on its early warning watchlist. Any delay in the flow of promised payments entails opportunity losses for a bank and raises the possibility that the borrower is in fact taking a first step on the road to a partial or complete default.

In the U.S., privately supplied software for analyzing bank loans and other kinds of counterparty risk is an important managerial innovation whose applications are expanding and whose use in consumer, mortgage, and even commercial lending use is
spreading rapidly. Treating Corrigan's assertion about "banking problems" as a scientific hypothesis about bank risk that is applicable to developing countries implies that initial efforts to transfer risk-based capital standards to developing countries ought to concentrate on using existing U.S. credit-analysis and database software as a paradigm for improving the information and credit-analysis systems used in developing economies. Credit-Apglication EIles As **a** Datahase TO qualify for a bank loan, every would-be borrower must provide enough information on its affairs and prospects to convince the bank that it is prudent to advance the funds requested. Bank credit analysis turns on an assessmcnt of the traditional "five Cs" of creditworthiness: character, capacity (or cash flow), capital, collateral, and conditional economic invulnerability (Sinkey, 1992, p. 515). Any bank's loan application formn can be regarded as a questionnaire that seeks to extract infornation on these attributes. Analysis of this information by bank credit experts looks to assign a riskrating to the various deals that customers offer.

"Character" is a subjective variable that summarizes a borrower's reputation for probity and fair play. Lenders prefer to deal with honorable parties who are detemined to live up to their obligations if they possibly can. Bank files on character begin with the information that each applicant supplies on its credit history. Borrower honesty is assessed by testing this infornation against credit-bureau and other data-service files and by cross-checking other falsifiable facts with suppliers, customers, and other lenders. Additional evidence is sometimes collected by asking around about the fuim's reputation in the communities and markets in which it operates.

Double-checking applicant-supplied information is an important test of character. This is why it would be useful for the World Bank or BIS to help developing countries establish or strengthen the presence or competence of private credit bureaus and credit rating agencies. Because government as well as private debt needs to be rated in these countries, it would also be beneficial to seek ways to insulate the work of creditinfornation agencies from political influence.

The other four "Cs" focus on the borrower's ability to pay. They seek to clarify how funds to repay the loan can be generated. Data for analyzing a business firn's capacity and potental vulnerability to changes in economic conditions ame collected in the **form** of business plans and from questions that focus on management skills and
16 experience. This part of the loan file describes the company's markets, customers, suppliers, competitors, and depth of management. The purpose of collecting this information is to establish whether the borrower can use the loan proceeds productively. The database includes the firm's past income statements and tax returns. It also should contain the firm's formal projections of cash flow, earnings, interest, and taxes.

Capital measures the value of resources from which a borrower might still repay the loan even if the project being financed works out poorly. A borrower's capital is measured in the same way as a bank's own capital. Data for calculating capital come from business balance sheets and supplementary data on value of relevant intangible assets.

Collateral represents supplementary ways to enhance a borrower's credit so as to qualify the loan for a more favorable interest rate. Lenders look for outside guarantors and for assets whose title can be pledged to the lender to curtail the banks' , xposure to loss if the borrower should fail to deliver the stream of repayments promised. EXoert Sstems for **Credit AnaIl** The object of credit analysis is to determine the odds that a particular loan will go bad. The information-processing activity of seasoned credit professionals or "experts" can be likened to an artificial intelligence system (Singleton and Surkan, 1991).

Expert systems for credit analysis seek to objectify and automate routine parts of the process of assigning and aggregating bond-issuer or customer scores for the five Cs of creditworthiness. The goal is to approximate the probability-formation process that experts go through in trying to assess the financial condition and stability of potential borrowers. This means positing n proxy variables that can be interpreted as theoretically relevant credit attibutes (Aj, j=1, ..., n) and incorporating these variables into a statistical model of the probability of default for a given loan to the kth borrower, Pk. The various attributcs that characterize a given borrower (say, the kth customer) come from reported facts and estimated economic exposures.

The specific value the jth attribute takes on for bank borrower k can be denoted by Ajk. The Aj include economic, financial and personal variables: loan terms; borrower characterstics; applicable economic conditions; and legal constraints the bank may face (e.g.. on their ability to foreclose against loan collateral).
17 Specific attributes that are widely used in mortgage lending include: the loan-tovalue ratio; the borrower's delinquency record; the borrower's occupation; the number of dependents in the borrower's family; and the ratio of the mortgage payments to family income. In the U.S. the Equal Credit Opportunity Act prevents many personal attributes from being ltgally used in such models. In particular, neither gender, national origin, race, religion, marital status, nor receipt of public assistance may be used in credit decisions.

Specific attributes useful in scoring business loans or corporate bonds include industry and macroeconomic trends and income and balance-sheet information such as leverage, interest coverage, return on equity, and earnings volatility. Zeller (1993) discusses opponunities for linkihig business credit-scoring models to larger models of macroeconomic and industrial ac.tv'Acy.

In practice, to prevent estimated default probabilities from rising above unity or falling below one, credit scoring models must be nonlinear. However, the following linear form provides a convenient way to illustrate these models' logical flow: n Pk - ao + 2j Ajk + ukj. j=1 Using this model, the coefficients aj may be interpreted as marginal risk coming from attribute j and the value Pk provides a direct measure of the per-dolla **r** isk weight the bank's capital would face in making the loan. The focus of credit scoring is to predict statistically the likelihood that specific customers will prove "slow-paying, **"** delinquent," or "pass into formal default." In the finance literature, statistical research has been used to derive and validate the attributes included in models for different types of loans (e.g., Altman, cLaL 1981; Boyes, Hoffman, and Low, 1989; Chesser, 1974; and Chhikara, 1989).

To adapt one or more of the models validated in this literature to the context of an individual bank and country, countries may be divided into three broad classes. Analysts must begin by ascertaining whether loan officers routinely collect infornation on the attributes featured in one or more of the previously validated models. In countries where necessary data are not yet collected at the bank level, a useful reform would be to impose a better information system on domestic banks. For countries that currently satisfy or
18 come to meet data-availability requirements for one or more models, parameters can be estimated and tested for reliability by using a sample of loan applications that have been screened and approved at designated banks by their own loan officers. Finally, in countries and banks for which statistical analysis can approve at least one model for transfer to their competitive environment, significant differences in estimates of marginal risks and of the average risks weights attached to different classes of loans can be used by World Bank or BIS analysts in cross-country analyses of asset risks and used by country supervisors as the basis for empirically based country-specific and bank-specific estimates of default probabilities.

When and as they are validated, credit-scoring models provide an empirical method for answering a number of tough supervisory questions. First, for what classes of assets (if any) does it make sense to set low or zero risk weights in a given country or class of countries? Second, how much safer or riskicer on average are a bank's clams on a developing county's government and public enterprises than its loans to private enterprises? Third, what minimum ratio of capital to assets may safely be deemed prudent for specific developing countries?

A scoring model can also be thought of as streamlining bank file structures and even automating the loan decision. In this conception, computer software treats infornation collected in loan applications as survey data and formulates a preliminary estimate of the bank's optimal loan response. Of course, final decision processes must include procedures for varying this response to make use of intuitive informnation that loan officers develop in ways that are not yet objecively reproducible. In straightforward cases, credit evaluation time may be reduced to a few hours. One U.S. software vendor, Appro Systems in Louisiana, claims that its software can produce a preliminary loan approval-or-denial decision in minutes.

It would be a mistake to dismiss loan-analysis software as too sophisticated for use by developing countries. In some developing countries, automated teller machines (ATMs) and applications of banking software are proliferating rapidly (Kraus, 1992). In fact, Fiserv Inc. has already contracted with four countries in the Northem tier of Latin America (Mexico, Honduras, Colombia, and Venezuela) for Spanish-language versions of its banking software (Sullivan, 1993).
19 The priority problem lies not in designing futuristic software bLt in improving the quality of data available for model testing and implementation. By means of touchscreen ATMvs and cartoon characters, even illiterate customers can be helped to fill out loan applications electronically. Expert systems constitute a change in technology that lessens rather than increases the skill demands being placed on loan officers and at the same time makes their job performance and instances of corrupt and fraudulent behavior easier for supervisors and examiners to monitor.

Besides tracking changes in risk, evidence of changing default probabilities can also be used to set up a market-based approach for establishing a watchlist and reserving for loan losses. Whether used to automate loan decisions or merely to monitor them, credit-scoring models can be used for timely identification and prompt downward or upward revaluations of problem loans. Updated data on borrower attributes can be used to track the changing probability of default fir a loan has been made. While post-loan revaluation is still at an early stage of development, American Management Systems, Inc. has developed what it calls a Strata software system that uses scoring models to predict a customer's disposition to pay back a delinquent loan.

Outside Monitoring oVa Bank'q **Credit Anal si** Credit analysis may be conceived as a management system that conducts statistical and sensitivity analyses of the credit-application database. These analyses have two principal objectives: to calculate applicants' repayment probabilities and to value the lending opportunities being offered to the bank. In every loan made, managers should bc able to identify the risks in the deal and how much the bank is being paid for bearing these risks. Each contract must be structured to offer a risk-return combination that makes the probability of repayment and the loan interest rate high enough to promise a reasonable total profit on the loan.

Outside stakeholders need to monitor and second-guess a bank's risk-classification and pricing procedures. Bank examination is a process that looks to test a bank's information and management systems for flaws. The first requirement of effective supervision is access to the data and assumptions from which the bank calculates repayment probabilities and asset values.

Even in G-1O countries, supervisory technology falls far short of technological possibilities. Increasingly, in these countries the data and assumptions an examiner needs
20 to evaluate will be objectified and "wired" into expert systems and intelligent workstations at individual banks. As we have seen, expert systems now exist that estimate the risk embodied in individual loans. The process of aggrega1.&g these estimates into measures of a bank's overall pofQjol risk is an exercise in applied portfolio theory that the Basle Agreement has yet to address. The resolution of this aggregation problem, when it is addressed, will turn on being able to esmate the extent of pairwise correlations between returns on individual loans.

Whether or not concentration risk is measured formally, it is reasonable for government examiners to develop their own standardized expert system as a benchmark for analyzing the loan portfolios of individual banks. It is also reasonable for them to seek to co-ordinate and standardize system architecture and inforTnation file structure across banks. This is true whether or not the bank being examined yet uses computer software to conduct credit analysis. In developed and developing countries alike, examiners and top bank managements share an interest in automating bank credit files and internal risk analyses at reasonable speed. At a minimum, loan deWisions need to be linked specifically to an information file of borrower characterisdcs and prospects. This file begins with the data would-be borrowers furnish in loan applications, but this database needs to be updated routinely as time passes and loan proceeds are collected or delayed. As a country's banks convert to electronic files, monitoring costs can be minimized if supervisors insist that banks cooperate in designing ways to input their files into "transportable" private credit-rating and govemment examination systems.

Banks and supervisors in G- 10 counties must make progress on these problems before authorities in developing countries can be expected to do much about them. But the systems developing countries adopt today should be made ready to incorporate systemic changes that can be confidently predicted to occur in institutions and countries that are technologically more advanced.

G- 10 countries need to set up (and therefore may **be** expected to establish) three separate but complementary information subsystems. These subsystems would respectively track: (a) the market values of securities that trade in secondary markets; (b) changes in the repayment prospects of loans; and eventually (c) the effects of changes in interest rates and foreign-exchange rates on the value of the institution and its economic income. As they build shese subsystems, economic efficiency dictates that the valuation
21 and rstk-analysis software they use be made accessible to bank examiners in differ-nt countries and responsive to the dynamics of financial-institution balanlce sheets.

In the meantime, supervisors in developing countries can usefully be encouraged to develop information systems that are compatible with the PDV methods of bank capital appraisal described in section II. For each of the major portfolio categories a bank's balance sheet and income statements delineate, top managers can be asked under penalty of fraud to project, defend, and discount the range of cash flows they deem likely to accrue.

Concentrating **on Tdentifving and TraCking the Changing Value of Problemn Loans** Within the U.S., state and federal regulators share information about the loars and investments that their respective bank examiners classify adversely. International sharing of supervisory information is equally important and already occurs to some extent through the Bank for International Settlements (BIS). The World Bank and BIS should explore opportunities to extend the scope of this information sharing to a broader group of countries.

More generally, the World Bank or BIS might speed up the spread of the needed information systems and coordinate supervisory standards across developing countries in three ways. First, they could become producers of internationally transferable creditanalysis and regulatory information protocols and valuation software. Second, on an international or regional basis, they could serve as forums for negotiating itemization and valuation rules that would use expert software to recognize incipient loss accruals and to assign accruing losses to specific bank stakeholders. Third, they could test and disseminate risk infornation to help the financial-services industry to set up a global secondary market for developing-country loans. Enhancing the liquidiLy of these loans would tend to reduce prescriptive levels of capital requirements for banks in developing countries and the cost of capital to customers of these banks.

In the years to come, these institutions could usefully disseminate a range of valuation and credit-analysis models that follow behavioral scoring models in being conceived as methods for analyzing pertinent information reported in credit-application data, credit-bureau or credit-rating files, and payment records. These models should strive to follow U.S. software systems in planning to employ scoring models to predict a customer's disposition to pay back a loan when and as it becomes delinquent. The
22 resulting scores can be used as a basis both for establishing loss reserves and for fine tuning collection efforts (i.e., "dunning" activity) to the probable responsiveness of various customer subsets.

Timely problem-loan identification turns on tracking the changing probability of default _&fl_ a loan has been made. In the U.S., software for tracking this probability is evolving out of credit-scoring and debt-collection softwar. Risk scoring for loan recovery is not fundamentally different from the risk scoring that is undertaken during a bank's initial underwriting process. It is natural for banks to repeatedly re-feed changing economic conditions, legal constraints, and borrower circumstances into the loan scoring framework as each loar noves forward through time. Doing this will ultimately provide an operational way of implementing market-value accounting for bank loans.

# **TV. Political Emhracahi1itX! Better Tnform2tion SyXstems As a ResDlonse to Market Pressures Faced by RegulatorX Enterprises**

Financial regulation is a service that regulated institutions value for the benefits of confidence and convenience it confers on customers who use their products (Kane, 1988). Regulators do not and cannot autonomously command and control the behavior of the "client" institutions they regulate. Rather, each regulator's panel of control instruments. is shaped by prior conditioning and ex post feedback from the parties it regulates (i.e., its "regulatees"). To survive, a control must be voluntarily accepted by regu!atees in the long run. Unacceptable controls lead regulatees and their competitors to engage in "regulatory arbitrage" that effectively transfers market share from inefficient to efficient regulators. In developing countries, regulatory arbitrage typically shifts business from regulated firms to less-formal underground institutions (Germides, Kessler, and Meghir, 1991) and to offshore entities.

The existence of competing regulatory arrangements supports a long-run voluntariness in regulatory relationships that creates strategic parallels between operating a regulatory agency and operating an ordinary business. To succeed in the long run, even a regulatory enterprise must deliver a quality product at a fair price. Emphasizing this point may help the World Bank and BIS to make the information systems recommended here more palatable to supervisory authorities in developing countries.
23

# **The Concent of a Regulatnr's P**

The equivalent of the 2d= of a regulatory system is the net buden it places on its regulatees. This net burden differs from the "gross burden" of regulation in two ways. First, it subtracts out the benefits in customer confidence and transactional efficiency that the regulatory system confers on its regulatecs. Second, it further eliminates whatever cos.. of operating the regulatory svstem can be successfully shifted to unwary taxpayers.

As a price, each regulator's net burden responds over time to opportunities for substitution. Competition from differentially regulated institutions and other market forces lead regulated parties to do two things: (1) to push for less-burdensome rules and (2) to adapt their economic strategy and organizational form to reduce the opponunity costs that tht regulation would create for their firms if managers were to comply with existing rules zrindkessly. For this reason, the cost of inefficient regulation tends ovcr time to shift from cos, of strict "compliance" to costs of undertaking efficient regulatory arbitrage. In turn, the cosi nf regulatory arbitrage is the cost of adapting a regulatee's product line, productih nr dist-iution systems, business locations, and corporate structure to make it possible to engage in profitable activities from which the firm would otherwise be excluded.

Net regulatory burdens differ drastically between strong and weak banks. Weak banks receive subsidies from deposit insurance and less-formal government guarantees that strong banks and general taxpayers eventually help to pay for. In the U.S., the net burden on strong banks has been increasing secularly in two respects. First, socialpurpose regulation (whose benefits are directed outside the industry) has generated increasing paperwork. Second, regulatory efforts to retard the exit of inefficient and insolvent deposit institutions lower the profit margins that strong firms can earn on borrowed funds and push their deposit-insurance premiums above the value of the guarantee services these low-risk institutions receive.

The counterparts of social-purpose regulation in developing countries are credit allocation policies that directly subsidize loans to preferred sectors and individuals. If applied to weak and strong banks alike, World Bank promulgation of standardized schemes for evaluating bank loans would broaden the market for the equities of banks **_It_** developing countries (Cho, 1986) and lessen a government's abiiity to subsidize inefficient borrowers and crippled institutions in a h:dden fashion.
24 A reasonable immediate goal for coordinated supervision is merely to agree to enforce much higher global net regulatory burdens for weak banks. To achieve this goal, it is enough to make sure that all banks hold positive enterprise-contributed capital without bothering to calibrate a precise risk-weighting scheme to justify variation in the enforcement threshold (Shadow Financial Regulatory Committee, 1989). However, if a risk-weighted threshold is to be adopted, it ought to embrace two additional goals. First, it should seek to mieasure the net regulatory burden comprehensively and equalize the burden it lays on a nation's strong banks with that of competing financial-services firms. Second, the system should seek to equate the part of the burden each nation's banks are allowed to shift to taxpayers with the benefits of the social-purpose responsibilities that the government specifically asks its banks to shoulder.

One way or another, the law of one price tells us that market pressures on every nation's banks and banking regulators will accomplish both types of equalization in the long run. The question is whether this can be done without first transferring much of domestic banks' financial-market share to foreign firms and other domestic financial institutions. The key to speeding up healthy regulatory and banking market-structure adjustments in any country is to make a crippled bank's economic insolvency and reliance on taxpayer-contributed capital harder to cover up.

Co)nflicts Between Overt and Covert Ggals Financial regulators make and enforce rules. These rules restrain the activities of individual financial-services firmns (FSFs) to generate overt and hidden benefits for various parties in society. Regulators' overt goals may be identified as promoting the stability, efficiency, and fairness of the financial industry. A regulatory enterprise's bureaucratic interest can be proxied by its administrative jurisdiction, the size of its annual budget, or the capitalized value of something akin to the enterprise's net income. Hidden benefits typically originate in unresolved conflicts of interest among regulators (including politicians), regulatees, FSF customers, and ordinary taxpayers. These conflicts of interest generate incentives that explain antiegalitarian redistributional government policies that enrich some politicians, some bureaucrats, and/or some segments of society at the expense of society as a whole.

What society views as poor regulatory outcoli1es sometimes trace to mistakes by misinformed individual regulators and sometimes to an unsavory pursuit of hidden
25 agendas. Economic analysis can portray managers of a regulatory enterprise as inaximizing the goals set by their overt mission, subject to technological, market, and statutory restraints aiid to various principal-agent conflicts. Such a model can also treat individual regulatory enterprises in different countries or in different financial-services industries as being locked in competition with one another for whatever measure of value their managers maximize (Scott, 1977). An enterprise's true objectives may embody tradeoffs between the performnance of its overt social mission, its covert bureaucratic and political interests, and its managers' reputations and narrow career interests. To align public-service incentives more closely with taxpayer interests, information systems for mcnitoring banks in developing countries must permnit taxpayers to monitor more effectively the long-run burdens their agent regulators actually impose upon them.

**Regulatory** Arbitrage as **a Force for Net-Benerit Convergence**

Around the world, financial institutions and markets and concomitant regulatory systems show numerous country-specific features (Wilson, 1986; Germides, Kessler, and Meghir, 1991). Differences in pattems of financial regulation parallel differences in the particular economic, political, and bureaucratic deficiencies and inefficiencies that regulation is overtly or covertly expected to correct.

However, the survival of differences in regulatory patterns is limited by the tendency of private capital and loan-making opportunities to flow to markets and institutions that offer the best deals. The extent to which net regulatory burdens on financial markets and institutions differ across countries is na.Towed by this regulatory arbitrage. When and as technological change in information processing and telecommunications lowers the cost of tra.isacting with foreign entities, adverse flows of capital and financial deals should help to persuade a nation's authorities to lower the net burdens their regulatory framework imposes on the savers, investors, and financial intermediaries that transact in its financial markets.

Recognition that exploitive regulation drives depositors, borrowers, and other bank stakeholders to book their business in foreign and less regulated or informal domestic markets limits the extent to which a country can set short-run burdens that deviate from its society's optimal long-run path. For any country, the size of efficient deviations increases with the opportunity costs its citizens would face in engaging in capital flight. These costs evolve with information costs, the volatility of the real
26 economy, and the fluidity of the political environment. This knowledge should help the World Bank to convince authorities in developing countries that the infornation revolution that is underway in finance today makes it short-sighted and unfair to adopt policies that intentionally or unintenti-naily permanently subsidize weak banks.

# REFERENCES

Altman, Edward, Robert Avery, Robert Eisenbeis, and Joseph Sinkey, 1981. Uplicatin of Classification TechniQues in Business, Bankine and Finance, Greenwich, Conn.: JAI Press.

Berger, Allen, K K. King, and J.M. O'Brien, 1991. "The Limitations of Market Value Accounting and a More Realistic Alternative," Journal of Banking and Finance, 15 (September), pp. 753-783.

- Boyes, William, Dennis Hoffman, and Stuart Low, 1989. "An Econometric Analysis of the Bank Credit Scoring Problem," Joumal of Econometrics, 40, pp. 3-14.

Brock, Philip E. (ed.), 1992. If Texas Were Chile: A Primer on Banking Reform. San Francisco: ICS Press.

Chesser, D.L., 1974. "Predicting Loan Noncompliance," Journal of Commercial Bank Lending, 56, pp. 28-38.

- Chhikara, Raj, 1989. "The State of the Art in Credit Evaluation," American Journal of Agricultural Economics (December), pp. 1138-1144.

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Demirgdi-Kunt, Asli, 1992. "Creditor Country Regulations and Commercial Bank Lending to Developing Countries." Washington: The World Bank.
27

- DemirgUt-Kunt, Asli, and Harry Huizenga,<sup>1992. "Barriers to Portfolio Investments in</sup> Emerging Stock Markets," Washington:<sup>The World Bank.</sup>

- Eisenbeis, Roben A., 1992. "Seminar<sup>on Banking Reform in Chile," Aide-Memoire</sup> Prepared for the Inter-American Development<sup>Bank (Nov. 30).</sup>

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- =__ 1992. "Bank Supervision Guidelines:<sup>Capital Adequacy," Washington: The</sup> World Bank, Financial Policy and Systems<sup>Division.</sup>

- Hall, Maximilian J.B., 1990. "Officially Imposed<sup>Impediments to a Level Playing Field</sup> in International Banking: A Comparative<sup>Study of the UK, US, and Japanese</sup> Approaches Adopted Towards the Implementation<sup>of the BIS 'Rule' on Capital</sup> Adequacy Assessment." (Nuffield University,<sup>unpublished).</sup>

- Kane, Edward J., 1985. The Gathering<sup>Crisis in Federal Deposit Insurance. Cambridge,</sup> MA: MvIT Press.

- _______ 1988. "Hcw Market Forces Influence the<sup>Structure of Financial Regulation," in</sup> W. Haraf and R.M. Kushmeider (ed.), Restructuring<sup>Banking and Financial</sup> Services in America, Washington: American<sup>Enterprise Institute for Public Policy</sup> Research, pp. 342-382.

- Kraus, James R., 1992. "Developing<sup>Nations Offer a Hot Market," Amerrican anker</sup> (December 22).

- Mayer, Martin, 1993. "Testimony," U.S.<sup>Senate Committee in Banking, Housing, and</sup> Urban Affairs, The State of the Banking<sup>Industrv and the Bank Insurance Fund,</sup> Hearings (June 9-10 and 17, 1992; July<sup>29, 1992; October 26, 1992), Washington:</sup> Government Printing Office, pp. 809-817.

- Polizatto, Vincent P., 1990. "Prudential<sup>Regulation and Banking Supervision: Building</sup> an Institutional Framework for Banks,"<sup>Policy, Planning, and Research Working</sup> Paper, Washington: The World Bank.

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28

- Scott, David H., 1992. "Revising Financial Sector Policy in Transitional Socialist Economies: Will Universal Banks Prove Viable?," Policy Research Working Paper Series 1034, Washington, D.C.: World Bank (Nov.).

- Scott, Kenneth, 1977. "The Dual Banking System: A Model of Competition in Regulation," Stanford Law Review, pp. 1-50.

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- Singleton, J. Clay, and Alvin J. Surkan, 1991. "Modeling the Judgement of Bond Rating Agencies: Artificial Intelligence Applied to Finance," Journal of the Midwest Financial Association, 20, pp. 72-80.

- Sinkey, Joseph F., Jr., 1992. Commercial Bank Management in the Financial-Services Indus= (Fourth Edition), New York: Macmillan Publishing Co.

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**Pollcy Research Working Paper Series**

|**Title**|**Author**|**Date**|**Contact**<br>**tor paper**|
|---|---|---|---|
|WPS1221 Does Research and Development<br>Contribute to Eoonomic Growth<br>in Developing Countries?|Nancy Birdsall<br>Changyong Rhee|November 1993|S. Rajan<br>33747|
|WPS1222 Trade Reform in Ten Sub-Saharan<br>Countries: Achievements and Failure|Faezeh Foroutan<br>s|November 1993|S. Fallon<br>38009|
|WPS1223 How Robust Is a Poverty Profile?|Martin Ravallion<br>Benu Bidani|November 1993|P. Cook<br>3S902|
|WPS1 224 Devaluation in Low-inflation<br>Economies|Miguel A. Kiguel<br>Nita Ghei|November 1993|R. Luz<br>39059|
|WPS1225 Intra-Sub-Saharan<br>African Trade:<br>IsRToo Little?|Faezeh Foroutan<br>Lant Pritchett|November 1993|S. Fallon<br>38009|
|WPS1226 Forecast.ng Volatility in Commodity<br>Markets|Kenneth F. Kroner<br>Devin P. Kneafsey<br>Stijn Claessens|November 1993|F. Hatab<br>35835|
|WPS1227 Designing Water Institutions:<br>Market Failures and Institutional<br>Response|Marie Leigh Livingston|December 1993|C. Spooner<br>30464|
|WPS1228 Competition, Competition Policy,<br>and the GATT|Bernard M. Hoekman<br>Petros C. Mavroidis|December 1993|L. O'Connor<br>37009|
|WPS1229 The Structure, Regulation, and<br>Performance of Pension Funds in<br>Nine Industrial Countries|E. P. Davis|December 1993|P. Infante<br>37642|
|WPS1230 Unemployment in Mexico: Its<br>Characteristics and Determinants|Ana Revenga<br>Michelle Riboud|December 1993|R. Stephen<br>37040|
|WPS1231 Making a Market: Mass Privatization<br>in the Czech and Slovak Republics|Nemat Shafik|December 1993|A. Correa<br>38549|
|WPS1232 Will GATT Enforcement Control<br>Antidumping?|J. Michael Finger<br>K. C. Fung|December 1993|N. Artis<br>37947|
|WPS1233 Hedging Cotton Price Risk in<br>Francophone African Countries|Sudhakar Satyanarayan<br>Elton Thigpen<br>Panos Varangis|December 1993|D. Gustafson<br>33714|
|WPS1234 Price Formation, Nominal Anchors,<br>and Stabilization Policies in Hungary:<br>An Empirical Analysis|Andr6s Solimano<br>David E. Yuravlivker|December 1993|S. Florez<br>39075|
**Policy Reaearch Working Paper Serles**

|**Title**|**Author**|**Date**|**Contact**<br>**for paper**|
|---|---|---|---|
|WPS1235 Eastern Europe's Experience with<br>Banking Reform: Is There a Role for<br>Banks in the Transition?|Altredo Thorne|December 1993|N. Jose<br>33688|
|WPS1236 The Impact of Two-Tier Producer<br>and Consumer Food Pricing in India|Maurice Schiff|December 1993|S.**Fallon**<br>38009|
|WPS1237 Bank Performance and the Impact<br>**of**Financial Restructuring in a<br>Macroeconomic<br>Framework: A New<br>Application|Yavuz Boray<br>Hector Sierra|December 1993|C.**Urm**<br>30864|
|WPS1238 Kenya: Structural Adjustment in the<br>1980s|Gurushri Swamy|January 1994|**V.**Saldanha<br>35742|
|WPS1239 Principles of Regulatory Policy<br>Design|David E. M. Sappington|January 1994|WDR<br>31393|
|WPS1240 Financing the Storm: Macroeconomi<br>Crisis in Russia, 1992-93|c William Easterly<br>Paulo Vieira da Cunha|January 1994|R. Martin<br>39026|
|**WPS1241**Regulation, Institutions, and<br>Commitment in the British<br>Telecommunications<br>Sector|**Pablo**T. Spiller<br>Ingo Vogelsang|January 1994|B. Moore<br>3 261|
|WPS1 242 Financial Policies in Socialist<br>Countries in Transition|Boris Pleskovic|January 1994|M. Jandu<br>**33103**|
|WPS1243 Are Institutional Investors an<br>Important Source of Portfolio Investm<br>in Emerging Markets?|Punam Chuhan<br>ent|January 1994|R. Vo<br>31047|
|WPS1244 Difficulties of Transferring Risk-<br>Based Capital Requirements to<br>Developing Countries|Edward J. Kane|January 1994|P. Sintim-Aboagye<br>38526|