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Supervising and Regulating Banking Sector Activities

4 Bank Supervision and Regulation

4.4 Supervising and Regulating Banking Sector Activities

In order to be able to compare the supervisory environment in Vietnam with that of other countries in the region and with developed countries in general Tables 4.4 and 4.5 list some official supervisory variables. These variables are thought of as capturing quantitatively the degree to which supervisory authorities in Vietnam are capable of designing and implementing interventions with the objective of promoting a well functioning banking industry. The variable Official Supervisory Power shows that judging by the statues and legislation in place, the power of the supervisory authorities is as good in Vietnam and other developing countries as in developed countries. The extent to which the powers stipulated in the legislation translates into actual powers of implementation is addressed in depth in Section 5.2, which contains an in depth analysis of this issue.

Returning to Table 4.6 we look at the power of supervisory authorities to restructure and reorganize banks and declare a troubled bank insolvent. Here it is found that the Vietnamese authorities are on average bestowed with greater powers than that of other developing countries.16 However, when we turn to compare the Prompt Corrective Power Index (PCPI), which measures whether or not the law establishes predetermined levels of bank solvency deterioration that force automatic actions, such as intervention, it can be seen that the promptness by which the regulator can or will respond to problems in the financial sector is lower in Vietnam than in most other countries in the region.17 This indicates problems from the supervisor’s point of view to respond to changes in the banking environment quickly enough.

Finally, Table 4.6 and 4.7 show that the supervisory authorities have no or low independence from Vietnamese officials (see Section 5.2 for details on this issue), and this is no different from the situation in the other countries in the South East Asian region. However, Barth, Caprio and Levine (2001a) have shown in a cross-country analysis that there is no clear-cut relationship between supervisory independence and bank development or between supervisory independence and the level of financial efficiency or the level of NPLs. On this background, it is not certain that a more independent supervisory authority will be beneficial for the Vietnamese banking system.

16 It is analyzed whether the supervisory authorities have the power to restructure, reorganize and declare insolvency of a bank. The Restructuring Power Index rates between 0 and 3, and the Insolvency Power Index rates between 0 and 2, with higher values indicating greater power.

17 The Prompt Corrective Power Index rates between 0 and 6, with higher values indicating more promptness.

Whether or not the creation of an independent supervisory institution is beneficial for the SBV attempts to obtain more independence is the subject of Section 5.4.

Table 4.6: Official supervisory variables in South East Asia

Supervisors

Source: Calculated using information in Barth, Caprio and Levine (2001a, 2001b), and information from the World Bank office in Hanoi.

Table 4.7: Official supervisory variables in a global perspective

Supervisors

Source: Calculated using information in Barth, Caprio and Levine (2001a, 2001b), and information from the World Bank office in Hanoi.

18 It is analyzed whether the supervisory authorities have the authority to take specific actions to prevent

It would thus appear that while Vietnamese legislation is equal to or outperforms that of other countries of the region the autonomy and power to rapidly implement these laws is lacking in Vietnam compared to the other countries in the region. Given that a swift regulatory response is a key determinant of the ability of a country to successfully avoid a financial instability this is a serious shortcoming of the Vietnamese regulatory framework, which has to be addressed. This is further analysed in Section 5.2, which contains an assessment of SBV independence according to three different components of central bank independence.

Up until recently the distinction between the profit taking and the social duties of banking system was not clear in Vietnam. In addition, the uniqueness of banks as financial intermediaries is not well recognized, possibly due to past and to some extent present (see Section 6.2.2.3) practice of using financial institutions as means for implementing government policies in the pre-transitional period. As consequence a clear, generally agreed upon distinction between financial intermediation and social duties, is still not available. This also affects the general perception of banks and banking functions among especially the Vietnamese households. Here, a bank is regarded as a safe, a broker, or a distributor of government funds. Banking functions such as risk sharing, screening, and monitoring that are elsewhere regarded as intrinsic to banks have not until now been sufficiently acknowledged or emphasized in the Vietnamese context.

These factors have undoubtedly contributed to households’ preference for real assets to financial assets, which have kept them from forming a banking habit. The very same factors are likely to have dampened bank motivation to initiate financial innovation, leaving deposit products simple. The end-result can be a vicious circle where savers do not use the banking sector partly because the products on offer are not perceived as attractive, and the banking sector refrains from developing and supplying long-term and/or more advanced products because demand is low.

Another constraint on banking sector possibilities to offer more advanced products is, however, the legislative and regulatory framework for government attempts to regulate and possibly control the level and trend of activities in the banking sector. While it will be difficult to separate the overall demand effect mentioned above from the more direct legislative effect, one can compare bank activity supervision and regulation across countries from South East Asia. This provides an indication of whether the Vietnamese framework differs substantially from that of other countries in the region.

Table 4.8 and 4.9 contain five indicators that give an indication of bank activity regulatory variables and measures of the degree of regulatory restrictiveness on the

mixing of banking and commerce. It can be seen that the banking sector in Vietnam is very restricted when looking at which activities banks can engage in. Banks in Vietnam are generally prohibited from engaging in securities, insurance and real estate markets (index = 4), where in most other developing countries it is permitted (index = 2) or somewhat restricted (index = 3). However, Vietnam does not differ much from neighbouring Cambodia or China.

Table 4.8: Legal restrictions on banking activity in South East Asia

Securities Source: Calculated using information in Barth, Caprio and Levine (2001a, 2001b), and information from

the World Bank office in Hanoi.

Table 4.9: Legal restrictions on banking activity in a global perspective

Securities Source: Calculated using information in Barth, Caprio and Levine (2001a, 2001b), and information from the World Bank office in Hanoi.

The question of which organizational structure is most appropriate for banks to better ensure a well-functioning banking industry has generated considerable controversy and

debate among financial sector specialist. One side argues that allowing for diversification of bank business operations may be beneficial because it makes it possible for banks to capitalize on synergies that originate from these complementary activities.

The competing, negative point view identifies several reasons for why it might be beneficial to restrict the degree to which banks can engage in very diverse financial activities such as securities, insurance, and real estate activities etc., see also Barth, Caprio and Levine (2001a). These include:

1. Conflicts of interest may arise when banks engage in such diverse activities.

Banks may, for example attempt to dump securities on or shift risk to ill-informed investors so as to assist associated firms with outstanding loans.

2. To the extent that moral hazard encourages riskier behaviour by banks, they will have more opportunities to increase risk if allowed to engage in a broader range of activities.

3. Broad financial activities and the mixing of banking and commerce may lead to the formation of extremely large and complex entities that are extraordinarily difficult to monitor.

4. Moreover, large institutions may become so politically and economically powerful that it becomes very difficult (if not impossible) to discipline them.

5. In addition, large financial conglomerates may reduce competition and hence potentially the efficiency of the sector.

As the theoretical discussion remains unsettled, one inevitably turns to empirical analyses to see whether a clearer conclusion emerges here. First, the afore-mentioned recent cross-country empirical analysis by Barth, Caprio and Levine (2001a) indicates that restricting banking activities is negatively associated with bank development. Second, it is found that restricting banks from engaging in securities activities is strongly, negatively associated with less bank development. Third, the diversification of income sources through non-traditional bank activities is found to be generally positively associated with bank stability, especially in economies with active non-bank financial markets.

The fact that a recent empirical analysis indicates that fewer regulatory restrictions on the activities of banks have a beneficial effect on banking sector development and stability, gives food for thought. One potential explanation for this finding is that the exploitation of economies of scale is beneficial to the development and stability of the financial sector. Furthermore, banks could get incentives to behave prudently if fewer regulatory

restrictions increase the franchise value of banks. Also, one can speculate as to whether the enhanced stability results from the broader activities that diversify income streams and thereby create more stable banks. Finally, one could argue that high levels of government restrictions promote government power, and thereby (perhaps) create a bigger role for corruption, hindering bank performance and stability. While this is speculative, one has to admit that the results from and the discussion about the results by Barth et al. indicate that it may be worthwhile considering liberalizing the laws regarding which activities Vietnamese banks are allowed to engage in.