Bridge over ocean
1 October 2014 CFA Institute Journal Review

Financial Nexus: Efficiency and Soundness in Banking and Capital Markets (Digest Summary)

  1. Priyank Singhvi, CFA

In the wake of the global financial crisis, the soundness of banks has been an area of concern. Under an appropriate regulatory framework, the long-term stability of banks increases with an increase in the level of competition in the sector. Stability of the banking sector also increases with the development of capital markets.

What’s Inside?

The stability of the banking sector is a key ingredient in the stability of the global financial system. The authors use data from 63 countries to demonstrate that the stability of the banking sector is dependent on (1) the level of competition in the industry and (2) the degree of evolution in the capital markets.

How Is This Research Useful to Practitioners?

A higher degree of competition, under an appropriate regulatory framework, leads to increased efficiency in the banking system. This efficiency, in turn, contributes to an increase in the long-term stability of banks. The authors extend the understanding of the link between competition and the soundness of banks and introduce the evolution of capital markets as an additional explanatory variable. The degree of evolution in the capital markets contributes to the soundness of the banking sector not only by providing more avenues for firms to raise capital, and thereby limiting leverage, but also by supporting banks’ capacity to provide disintermediation services.

The authors find that these results are highly dependent on the level of economic development and the relative size of the banks and the banking system. Banks in countries with large banking sectors are more influenced by the market power of consolidation. The same tail dependence is reflected in the impact of capital market development and market turnover.

There are three key implications for policymaking from this study. First, although the importance of the scope and effectiveness of prudential regulations cannot be refuted, such regulations are not a substitute for market discipline. Second, policymakers cannot rely on a single measure of bank soundness and efficiency when determining prudential policies. Third, there might be some advantages in having a unified supervisory framework for the banking sector and the capital markets.

How Did the Authors Conduct This Research?

The authors consider a global data set that transcends the recent structural shifts driven by the global financial crisis, different sizes of banks and banking systems, and different degrees of economic evolution. Using an alternate framework, they investigate the factors that contribute to the robustness of the banking system. They determine drivers of the soundness of the banking sector by statistically analyzing data from the World Bank Global Financial Development database for 63 developed and developing countries during 1997–2010.

The dependent variable used in the regression is the default probability of a country’s banking system, calculated as a weighted average of the Z-scores of a country’s individual banks. The Z-score compares a bank’s buffers (capitalization and returns) with the volatility of those returns.

The main explanatory variables are the ratio of stock market capitalization to GDP and the Lerner index. The former is used as a measure of the degree of evolution of the capital markets. The Lerner index, a numerically calculated score that captures numerous banking sector variables, is used to indicate the degree of concentration in the sector in the short run. It can also be described as the difference between output prices and marginal costs.

Two control variables considered are the ratio of bank loans to deposits and the ratio of noninterest income to total income. The latter variable is a proxy for the efficiency in the banking sector, whereas the first variable is a proxy for the diversification of the resource allocation in banks.

Regime shifts are captured through an explanatory dummy variable that corresponds to the three main updates of Basel II in 2004, 2009, and 2010. The impact of the global financial crisis is captured by analyzing separately the pre-crisis (1997–2006) and post-crisis (2007–2010) periods.

Abstractor’s Viewpoint

The authors have established that the development of capital markets plays a critical role in the soundness of the banking sector. A specific study of the transmission mechanisms for the development of capital markets would further enhance understanding and help policymakers in designing unified prudential policies.

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