Regulating today’s modern banking system — João Granja

MIT Sloan Assistant Professor João Granja

MIT Sloan Asst. Prof João Granja

Years after a devastating crisis that spread from the U.S. across Europe and Asia, policymakers all over the world are still trying to come up with strategies to make sure that a financial crisis of that magnitude never happens again. One essential element of this task is building back the trust of the public.

When the every day participants in the financial system—the depositors, holders of short-term commercial paper of banks, and other bank investors—feel confident in the banks, the financial system stabilizes. Business runs more smoothly. And growth improves.

In the U.S. our faith in banks is abysmally low. According to a Gallop poll conducted in June, Americans’ confidence in U.S. banks stands at 26%, up from the record low of 21% a year ago. The percentage of Americans saying they have “a great deal” or “quite a lot” of confidence in U.S. banks remains well below its pre-recession level of 41%, measured in June 2007. Meanwhile, across the pond, only 19% of Britons say that banks are well managed, according to the British Social Attitudes Report released in September.

Perhaps the simplest way to instill confidence in the public is transparency. That is: to compel banks to provide full and complete balance sheet information. They must disclose more detailed information to the public on their holdings of securities, government bonds, commercial real estate, and commercial paper; they must reveal their amounts of equity and capital; and they should be more forthcoming about outstanding loans and other liabilities. There should be no such thing as “off balance sheet” assets.

The efficacy of reporting requirements tends to stir debate in the financial community. Proponents of public disclosure say the rules serve as effective incentives against risk and exert discipline over banks. Critics, on the other hand, argue the regulations are unnecessary and could set off bank runs.

My research suggests, however, that disclosure regulations have historically made the banking system more secure, not less. Using data from the National Banking Era—the late 19th century through to the creation of the Federal Reserve—I studied the impact of legislation requiring state banks to periodically publish their financial statements in local newspapers. Before that time, state banks operated under charters granted by local banking authorities, while national banks abided by federal regulations. (For my research, I used the federally regulated banks as a benchmark to track the effect of regulations as they were rolled out to state banks.)

I found that when bank regulation went into effect, the rate of bank failures decreased. Not only did bank customers put more money into long-term deposits relative to short-term ones, but the capital ratios of banks—the cushions that bankers offer to depositors against losses in their portfolios—declined, as well. This suggests that customers needed fewer assurances to entrust their money.

Why is this relevant? After all, our banking system today is far more global and far more complex than it was at the turn of the 20th century. But there are number of banking systems in the world that are not very complex; in fact, they look very similar to what the U.S. looked like in the 1900s. Even when they don’t perfectly resemble the U.S.’s crude, turn of the 20th century system, they have problems that could be solved with greater transparency.

Take the Vietnamese banking system, for instance. Five years ago, the country was riding high “as the sexiest of the Asian tigers,” as the Economist so memorably put it, but today the situation is very different. Corruption is rampant. The arrest of bank bosses has become a regular event. And there is a distinct lack of trust between depositors, international investors and banks.

There are a myriad of solutions to this problem. Vietnam ought to overhaul its regulatory system; it should create more stringent rules on cross-ownership; it ought to reduce state-ownership in the banking system. These all have an important role to play. But perhaps the best way to increase the level of trust among customers, investors and their financial institutions is to improve transparency. Adopting credible disclosure policies and international accounting standards that promote transparency in an underdeveloped banking system like Vietnam is a steppingstone to delivering financial stability and development.

Closer to home, I believe we should be wary of regulation that requires too much enforcement and relies on the benevolence of local regulators. It is an unfortunate inevitability that they will develop cozy relationships with the banks. Instead, we ought to implement disclosure laws that increase the transparency of the financial system and let the public do its part to discipline the banks.

Read more about Prof. Granja’s research in Science World Report

João Granja is Assistant Professor of Accounting 

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