Banking regulation and bank performance in the EU countries

The financial crisis of 2007-2009 revealed substantial drawbacks in the EU banking regulatory framework. The regulations put forward in Basel II were not enough to prevent unstable credit booms. Even countries with conservative banking regulation incurred large losses in their banking sectors. A reaction to the crisis was regulatory reform on national and supranational levels. The topic of the EU banking sector risk and performance has been broadly discussed in the economic literature. The ongoing changes in the regulatory framework and the planned regulatory reform render further research in this area necessary.

The aim of the study is to investigate the relation between the respective areas of banking regulation and bank performance in the EU countries during the period of 2004-2010. The study endeavors to examine which elements of banking regulation and supervision shaped banking outcomes in the EU countries before and after the crisis.  

The study uses balance sheet data for 493 EU banks from the period of 2004-2010 obtained from Bankscope and pre-crisis and post-crisis banking regulatory indicators obtained from the World Bank database. The data comprises regulatory restrictions on bank activities, regulations on bank entry, regulations on capital adequacy and asset quality, deposit insurance system regulation, supervisory power and private-sector monitoring of banks.

Building on an extensive strand of related literature the study investigates the relation between banking regulation and bank performance in a dynamic panel data framework. To tackle the problem of endogeneity in the relation between bank performance and bank characteristics the econometric methodology applied is the two-step GMM estimator (Arellano-Bover 1995 and Blundell-Bond 1998).

The results show that banking regulation as a whole did not significantly influence banking sector outcomes, however the newly introduced supervision rules of problematic institutions shaped bank performance significantly and positively. In countries where the supervisory authority was entitled to more powerful interventions in problematic institutions, banks performed better.

 The results also show that bank size affected bank performance. Bank individual size increased credit risk whereas bank systemic size increased liquidity risk. This might point to the conclusion that large banks require stricter regulation than smaller ones. This result is interesting since the new capital adequacy rules put forward in Basel III do not consider bank size as a subject of regulation.