Comment on "Regulations, Market Structure, Institutions, and the Cost of Financial Intermediation"

Abstract

This paper examines the impact of bank regulations, market structure, and national institutions on bank net interest margins and overhead costs using data on over 1400 banks across 72 countries while controlling for bankspecific characteristics. The data indicate that tighter regulations on bank entry and bank activities boost the cost of financial intermediation. Inflation also exerts a robust, positive impact on bank margins and overhead costs. While concentration is positively associated with net interest margins, this relationship breaksdownwhencontrolling for regulatory impediments to competition and inflation. Furthermore, bank regulations become insignificant when controlling for national indicators of economic freedom or property rights protection, while these institutional indicators robustly explain cross-bank net interest margins and overhead expenditures. Thus, bank regulations cannot be viewed in isolation; they reflect broad, national approaches to private property and competition.

"Regulations, Market Structure, Institutions, and the Cost of Financial Intermediation," by Demirguc-Kunt, Laeven, and Levine (2004, this issue of JMCB) offers another piece to a larger puzzle constructed over the past ten years linking finance to economic performance. Starting with King and Levine (1993), over the past ten years an impressive array of facts has been assembled supporting the proposition that the size and efficiency of financial markets and institutions can have a causal impact on long-run growth. We now know, for example, that predetermined measures of financial market depth predict future growth; that industrial sectors relying heavily on external sources for cash to support investment benefit more from good finance than industries that rely on internally generated funds (Rajan and Zingales 1998); and that financial liberalizations seem to be followed by faster growth (Jayaratne and Strahan, 1996, Bekaert, Harvey, and Lundblad, 2003).

The key challenge for this research has been to overcome the possibility that causality flows from the performance of the economy to the financial system, rather than the other way around. If financial resources seek the highest return, then we would expect a strong correlation between finance, return on capital, and economic growth. Where the economy leads, finance follows. The causality objection has been met by using timing, by emphasizing differential effects of finance across sectors, or by seeking plausibly exogenous policy or regulatory innovations. Any individual study is not fully convincing, but the totality of the results has persuaded many of us that finance can indeed have a causal impact on growth over the long run.

The questions of interest now are two. First, why does finance matter for growth? Second, what aspects of a legal and/or regulatory environment foster good financial markets and institutions (and, by extension, high levels of growth)? Demirguc-Kunt et al. make progress toward addressing this second question by linking dimensions of a country's regulation of banking, as well as its overall protection of property rights, to the cost and pricing of banking services. The authors take advantage of a new data set compiled by researchers at the World Bank. Leveraging off the Bank's connections with and influence over bank supervisors across the world, these data allow researchers for the first time to compare supervision and regulation policies across a large number of both developed and developing countries. This data-collection effort has been spearheaded by researchers at the World Bank, and their efforts are to be applauded.

The specific policy variables addressed in this paper include a country's willingness to allow foreign bank entry (the percent of foreign applications denied), a measure of the extent to which a country restricts bank activities (e.g., securities activities, insurance, owning or controlling commercial enterprises, etc.), and the central bank's reserve requirements. In addition to these specific bank policy variables, the authors consider broader measures of the banking and institutional environments in a country, with emphasis on an overall measure of banking freedom and a measure of how well a country protects property rights. These "institutional" variables have been constructed by the Heritage Foundation.

The paper's bottom line is that banks in countries...