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Basel regulations and banks' efficiency: The case of the Philippines

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DOI: 10.1016/j.asieco.2015.06.001

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 Journal of Asian Economics 39 (2015) 72–85

Contents lists available at ScienceDirect

Journal of Asian Economics

Full length article

Basel regulations and banks’ efficiency: The case of the

Philippines
Maria Chelo V. Manlagnit a,b,*
a
Department of Economics, University of Hawai’i at Mānoa, 2424 Maile Way, Saunders 542, Honolulu, HI 96822, United States
b
East-West Center, 1601 East-West Road, Honolulu, HI 96848, United States

A R T I C L E I N F O A B S T R A C T

Article history: Using stochastic frontier analysis, this paper has examined the impact of Basel II on the
Received 30 August 2014 cost efficiency of Philippine commercial banks from 2001 to 2011. The overall mean cost
Received in revised form 11 June 2015 efficiency estimate is 0.75, indicating substantial inefficiencies in the banks averaging to
Accepted 18 June 2015 25% of total costs. Findings show that higher capital requirement tends to improve the cost
Available online 26 June 2015 efficiency but more powerful supervisors can adversely affect the efficiency of the banks.
The other potential correlates that may help explain the efficiency of the banks are risk and
JEL classification: asset quality and bank-specific variables. From a policy perspective, this study is
E44
informative to policymakers on the general direction in which to proceed with reforms
E58
(i.e., maintain higher capital requirements, curtail powerful supervisors, and enhance
G21
private monitoring) and in identifying factors that could contribute to banks’ efficiency
Keywords: especially in light of the newly implemented Basel III in the country. In effect, this paper
Cost efficiency also assesses the readiness of the banks toward the implementation of Basel III.
Basel II ß 2015 Elsevier Inc. All rights reserved.
Stochastic frontier
Philippine commercial banks
Regulations

1. Introduction

Regulatory change, due to unprecedented changes and reforms on financial institutions and markets around the globe,
has greatly affected the efficiency of financial institutions in recent years. More particularly, the weaknesses in financial
regulation and supervision have been pointed out by several studies as one of the factors leading to the recent global
financial crisis that started in late 2007 (Dan, 2010; Lawrence, 2010; Levine, 2010; Merrouche & Nier, 2010; Barth, Caprio, &
Levine, 2012). The recent global financial crisis, as a consequence, did not only bring up critical questions on the
appropriateness of the current regulatory and supervisory approaches, but also prompted regulators to take into account the
important changes in regulation and supervision. In response to the recent crisis, several countries are in the process of
strengthening their regulatory and supervisory systems to improve crisis prevention and management.
Financial regulation and supervision, particularly in the banking sector, is often considered a controversial issue.
However, since banks play a major role in the well-being of the economy, there is a substantial need for developing public
policies that enhance bank operations. As such, most countries in the world are eager to adopt the ‘‘best practices’’ for the
regulation and supervision of banks advocated by the Basel Committee on Bank Supervision (BCBS), making them almost
universal standards for bank regulators. For example, virtually all countries adopted the 1988 Basel Capital Accord (Basel I)
and in 2004, within three months of its official announcement, more than one hundred countries already signaled their

* Corresponding author. Postal address: 3037A Kahaloa Drive, Honolulu, HI 96822, United States. Tel.: +1 8082034181.
E-mail address: mcm@hawaii.edu

http://dx.doi.org/10.1016/j.asieco.2015.06.001
1049-0078/ß 2015 Elsevier Inc. All rights reserved.
 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85 73

intention to adopt Basel II (Barth, Caprio, & Levine, 2006). Basel II, which is the revised and extended version of Basel I, is
based on three main pillars: minimum capital requirements, supervisory review and market discipline. Basel II was expected
to produce significant benefits in helping banks and supervisors manage risks, improve stability and enable market
participants to make better risk assessments (Molyneux, 2003). However, the recent global financial crisis has revealed many
shortcomings of the Basel II Accord that prompted the urgency of a revised capital adequacy framework1. In 2010, the new
proposed framework, Basel III, was issued. This new framework revises and strengthens the three pillars established by Basel
II. However, as pointed out by Demirguc-Kunt, Detragiache, and Tressel (2008), upgrading bank regulation and supervision is
a complex and difficult process especially in developing countries where the required expertise may be scarce, the legal
environment weak and governance problems may lead to regulatory capture.
The efficiency of banking institutions has already been reported considerably in the literature, with most studies
concentrated in the United States (US), and an increasing trend toward studies on European financial institutions. This
increasing trend seems to be partly motivated by the existing literature on growth and finance that suggests that the overall
economic success of a country is positively related to its financial sector development (e.g., Levine, 1997; Levine & Zervos,
1998; Rajan & Zingales, 1998, among others). The Philippine banking system is of particular interest for examining efficiency
and risk issues since it experienced substantial banking reforms since the 1990s, after being a tightly regulated banking
system. It is interesting to note that according to the series of World Bank surveys from 1999 to 2012, the Philippines is
among the top countries that advocate regulatory changes particularly on bank capital regulation and at the same time, has
the highest increase in restrictions on bank capital (Barth, Caprio, & Levine, 2008; Barth et al., 2012).
Using a stochastic frontier approach, the main objective of this study is to examine the impact of bank regulatory reforms,
particularly the effects of the three pillars of Basel II on the cost efficiency of Philippine commercial banks with the goal of
shedding light on how to prioritize efforts to improve supervision. More specifically, did the bank regulatory framework
prescribed by the BCBS increase the efficiency of commercial banks? Answer to this question will help the country adjust its
reforms and choose more appropriate reform strategies considering the significant increase in the demand for regulation
after the recent global financial turmoil. Using the methodology proposed by Battese and Coelli (1995), this study will also
identify possible determinants of efficiency of the banks.
From a policy perspective, this study is motivated by Barth et al. (2012) regarding what policy to pursue using data from
the extensive survey available. To the author’s knowledge, this is the first paper that uses the World Bank survey data by
Barth, Caprio, and Levine (2004), Barth et al. (2006) and deals with evaluating the impact of implementing Basel II in the
Philippines. In light of the newly implemented Basel III in the country last January 2014, it is imperative to know whether
these regulations have positive impact on the efficiency of commercial banks. In effect, this paper also assesses the readiness
of the commercial banks toward the implementation of Basel III in the country. Accordingly, this study will be informative to
policymakers on the general direction in which to proceed with reforms (e.g., whether to emphasize capital requirements,
bank supervision, or private monitoring) to improve and strengthen the country’s commercial banking system. At the same
time, this study is expected to help improve the regulatory and supervisory framework of the banking system in the country
by identifying factors that could contribute to their efficiency. Moreover, this study uses comprehensive banking data
compared to existing research on the effects of regulations on bank performance that typically relies on traditional measures
of bank efficiency and performance derived from simple accounting ratios.
The rest of the paper is structured as follows: Section 2 reviews the literature on banking efficiency particularly relating to
Basel regulations. Section 3 briefly describes the Philippine banking system and the major financial reforms it recently
underwent with respect to Basel regulations. Section 4 presents the empirical design for efficiency estimation, while Section
5 discusses the empirical results of the estimation and their implications. Section 6 concludes the paper.

2. Review of literature

2.1. Bank efficiency and Basel regulations

Given the plethora of studies on the effects of regulatory and supervisory policies on banks’ performance, this section
highlights the emerging themes from the extant studies on the effects of the three pillars of Basel II (capital requirements,
supervisory power, and market discipline) on banks’ performance. Studies on this particular topic are still very limited in
developing countries, in general and in Asian region, in particular.
Barth, Caprio, and Levine (2001) provide one of the first studies on the empirical evidence of the effects of the three pillars
associated with Basel II on bank performance. Using a series of surveys2 covering the period of 1999 to 2011, the authors’
major findings remained consistent throughout the period covered: first, the stringency of capital regulations (pillar 1) and

1
In 2009, to address the lessons of the crisis related to the regulation, supervision and risk management of global banks, the Basel Committee approved
for consultation a package of proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector (see
BIS, 2009).
2
The World Bank conducted an extensive survey of cross-country database on bank regulation and supervision. The first survey, Survey I, was done in
1999 covering 117 countries. This is followed by Survey II that described the regulation and supervision of 152 countries as of end-2002. Survey III
characterized the regulatory situation of 142 countries as of 2005–2006. The last survey, Survey IV, was completed in 2011 covering more than 125
countries.
74 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85

empowered supervisory agencies (pillar 2) are not closely linked with bank performance and stability; and second,
regulations that encourage and facilitate private monitoring of banks (pillar 3) tend to boost bank performance.
A related study of Demirguc-Kunt et al. (2008) uses bank-level investor ratings for 39 countries to investigate whether
compliance with the Basel Core Principles for Effective Banking Supervision (BCPs) improves bank soundness. The authors
find that countries that require banks to regularly and accurately report their financial data to regulators and market
participants have sounder banks. As such, the result emphasizes the importance of transparency in making supervisory
processes effective and strengthening market discipline. Such policy recommendation is consistent with the study of Barth
et al. (2001, 2004, 2006, 2008, 2012) that stresses the importance of mechanisms to empower market discipline (pillar 3) and
is skeptical of structures that assign too much power to regulators (pillar 2).
Although still in its infancy stage, there are studies that examined the effects of Basel II on the efficiency of banks using
parametric or non-parametric estimation techniques3. The study of Pasiouras (2008) using two-stage data envelopment
analysis (DEA) in 95 countries in 2003 provides evidence in favor of all three pillars of Basel II in promoting banks’ technical
efficiency. In another study, Pasiouras, Tanna, and Zopounidis (2009) examine the impact of regulations related to
restrictions on bank activities and the three pillars of Basel II on cost and profit efficiency of banks using stochastic frontier
analysis (SFA) in 74 countries during the period 2000–2004. The findings are in favor of supervisory power and market
discipline in increasing both the profit and cost efficiency; however, the results on capital requirements provide mixed
results.
A recent paper of Alam (2012) using DEA focuses on dual banking system in 11 countries over the period 2006–2010 and
examines the linkages between bank regulatory and supervisory structures associated with Basel II’s pillars. The findings
show that the efficiency of Islamic banks was positively influenced by regulations related to the second and third pillars
while the efficiency of conventional banks was negatively influenced. The results also show that stricter regulations related
to the first pillar had a positive impact on technical efficiency for both banks and that higher capital requirements induce
lower level of risk behavior for both banks. Also, the findings on pillar 3 indicate that excessive private monitoring and
regulatory restrictions on bank activities can affect the efficient operation of banks. In another study, using DEA, Chortareas,
Girardone, and Ventouri (2012) examine the dynamics between bank regulatory and supervisory policies associated with
Basel II’s three pillars and various aspects of banks’ cost efficiency and performance on a selected sample of European
commercial banks over the period 2000–2006. The results show that empowering capital restrictions, fortifying official
supervisory powers and private sector monitoring significantly impede the efficient operation of banks.
Little is known on the effects of Basel II on the efficiency of Asian banks since empirical work is almost non-existing. The
only extant study found by the author is done by Thangavelu and Findlay (2010). The authors examine the impact of bank
regulation and supervision on the efficiency of banks from 1994 to 2008 employing a two-stage DEA. Their findings show
that official supervision tends to improve the efficiency of the financial institutions in Southeast Asia but private monitoring
does not produce positive impact on banks’ efficiency.
In summary, although many countries have followed the Basel guidelines, existing evidence on the impact of Basel II on
bank efficiency is at best mixed. Given that the banking supervisors in the Philippines strongly advocate the implementation
of Basel guidelines and yet, existing studies is still relatively scarce, focusing on this concern is long overdue. Thus, this paper
will attempt to fill the gap in banking regulations and bank performance studies as it focuses on the analysis on Basel II and
bank efficiency from a developing country perspective.

2.2. Potential correlates of bank inefficiency

From the limited available studies, the determinants of efficiency have been developed on an ad hoc basis since there is no
established theory on the factors explaining measured efficiency. For example, some studies find that ownership and
location (Cebenoyan, Cooperman, Register, & Hudgins, 1993; Berger, Hasan, & Zhou, 2009; Barry, Dacanay, Lepetit, & Tarazi,
2010); age, size, and type of the bank (Mester, 1997; Manlagnit, 2011); managerial control and/or organizational structure
(Berger & DeYoung, 2000; Okuda, Hashimoto, & Murakami, 2002; Valverde, Humphrey, & del Paso, 2007); and economic
performance (Ferrier, 2001; Christopoulos, Lolos, & Tsionas, 2002; Pasiouras et al., 2009) as factors determinant of measured
efficiency among banks.

3. Reforms in the Philippine banking system

The Philippine commercial banking system, which dominates the banking system, represents the largest single group,
resource-wise, of financial institutions in the country and carries the greatest number of functions as well as the highest
minimum capital requirements. The improvement in the economy and the liberalization of bank entry and branching in the
1990s paved the way for the increase in the number of commercial banking institutions. However, due to structural changes
and competition, a continuous decline in the number of commercial banks since 1997 has been observed, as mergers and
acquisitions have increased. But still, the number of bank branches has remained almost the same at more than 4000. As of

3
See Berger and Humphrey (1997) for detailed discussion on these estimation techniques.
 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85 75

December 2011, there were 38 operating commercial banks in the country, down from 44 in 2001. The number of foreign
commercial banks was14, up from four before the liberalization in 1994.
Since the early 1980s, major reforms in the Philippine financial system have been introduced by the government to
improve its efficiency, not only in carrying out its tasks as intermediaries in the financial market but also to make it
financially strong enough to withstand adverse shocks4. For example, after the East Asian financial crisis in 1997, the
country’s central bank, the Bangko Sentral ng Pilipinas (BSP) implemented more reforms to improve the capacity of the
banking system to face the adverse shocks of the crisis, as well as to support the system’s institutional structure in dealing
with problem banks. The key reforms were focused on risk management, stronger capital base, and improved corporate
governance standards in the banking system.
At the same time, the Philippines has substantially implemented reforms on its commercial banking system to keep up
with the ‘‘best-practice’’ banking regulations recommended by the BCBS and to keep up with the international banking
standards. For example, the BSP has implemented Basel I in July 2001, covering credit risk only; and in July 2003,
incorporating market risk.
The adoption of the Basel II framework in the country for all universal and commercial banks and their subsidiary banks
and quasi-banks on both solo and consolidated bases started in 2007. Specifically, the first (minimum capital requirements)
and third (market discipline) pillars took effect in July 2007 while the second pillar (official supervisory power) took effect in
January 2011 and was made applicable to universal and commercial banks at a consolidated level only.
For the implementation of the said Accord, the BSP has prepared the local banks by gradually changing its regulatory
framework, enhancing corporate governance in banks, capacity building, and supporting the establishment of critical market
infrastructures, among others. Specifically, the BSP has issued a series of guidelines in strengthening BSP’s compliance with
the Basel Core Principles for Effective Banking Supervision, as well as with the international standards for corporate
governance; supported the development of the domestic credit ratings industry through the issuance of the recognition and
derecognition guidelines for credit rating agencies; and pushed legislative changes to its charter to include provisions
necessary for the effective implementation of Basel II (BSP, 2004).
The international standards under Basel requirements require that the capital adequacy ratio (CAR) for banks must not
be lower than 8%. To better address potential systemic risks, the CAR requirement in the country is more strict set by the
BSP at 10%. As of end-December 2011, the CAR of the banking system was at 17%, significantly higher than the 10%
statutory standard and certainly well above the international benchmark of 8%. Commercial banks have remained well-
capitalized at levels above both the BSP-regulatory requirement and the Basel Accord standard. Moreover, with the
implementation of Basel II, the banks are not only forced to reduce their risk assets but also compelled to consider
alternative strategies in fortifying capital and meet the requirements set by the BSP. It is noteworthy that according to the
surveys conducted by the World Bank, the country has the highest increase in restrictions on bank capital from 1999 to
2006 (see Barth et al., 2012).
Since banks are well-capitalized, the country’s commercial banking system adopted the capital adequacy standards
under Basel III in January 2014, four years earlier than the full timeline given by BCBS. Since the new framework will
significantly increase the quality and required level of banks’ capital, it is expected to strengthen banks’ capacity to absorb
risks and reduce the probability of future banking crises. Although Basel III covers new rules for both capital and liquidity in
the banking sector, the BSP implementation plan so far does not cover the liquidity standards of Basel III. A preliminary study
by Parcon-Santos and Bernabe (2012) on the macroeconomic effects of the implementation of Basel III in the country shows
that the higher capital requirements imposed by the new framework may have an initial negative impact on the country’s
economy but the estimated net effect of the implementation is positive but modest.

4. Theoretical model for estimation of cost efficiency

This paper uses the stochastic cost frontier analysis independently proposed by Aigner, Lovell, and Schmidt (1977) and
Meeusen and van der Broeck (1977), which is a means to measure the relative performance of banks by objectively providing
numerical efficiency values and ranking these accordingly. Under this methodology, a commercial bank is considered
inefficient if its costs are higher than those predicted for an efficient commercial bank producing the same output under the
same existing conditions with the difference unexplainable by statistical noise. In this way, it shows how close banks are to
the ‘‘best-practice’’ frontier. Specifically, a stochastic cost function model implies that a bank’s observed total cost will
deviate from the cost-efficient frontier, i.e., minimum or best-practice cost frontier, because of random noise and possible
firm inefficiency. For panel data, the cost function can be written as

lnTCit ¼ lnTCðyit ; wit ; bÞ þ eit (1)

5
where TCit is the observed total cost of production at the tth year (t = 1, 2, . . ., T) for the ith bank (i = 1, 2, . . ., N) ; yit is the vector
of banking output; wit is the vector of input prices; and b is a vector of unknown coefficients for the associated output and
input price variables in the cost function. Thus, ln TC(yit, wit, b) is the predicted log cost function of a cost minimizing bank

4
See Manlagnit (2011) for the discussion on the earlier major reforms in the Philippine commercial banking system.
5
It is not necessary that all banks are observed for all T periods although it is assumed that there are T time periods for which observations are available.
76 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85

operating at (yit, wit). Following Aigner et al. (1977), eit is the error term of the cost function for the ith bank which can be
written as

eit ¼ vit þ uit (2)

where vit represents errors of approximation and other sources of statistical noise assumed to be independent and identically
distributed as Nð0; s 2v Þ and uit is a random variable which is assumed to be an independently but not identically distributed
non-negative random variable.

4.1. Data and definition of variables

This study uses data from the balance sheets and income statements of individual domestic commercial banks obtained
from the Philippine Securities and Exchange Commission (SEC) for the period 2001 to 2011. The panel data, which consist of
186 observations, include 17 commercial banks whose assets accounted for 70% and 80%, on average, of the total assets of the
whole commercial banking system and the domestic banking system, respectively. These 17 domestic banks, which meet the
minimum requirements of having a complete data set that covers at least seven years, are comprised of 10 universal banks
and 7 commercial banks. Meanwhile, data for the regulatory and supervisory variables are obtained from Barth et al. (2001,
2004, 2006) World Bank (WB) database.
Although there is no consensus on the explicit definition and measurement of banks’ inputs and outputs, this study uses
the intermediation approach proposed by Sealey and Lindley (1977). According to this approach, banks as financial
intermediaries use labor, capital, deposits, and other borrowed funds to produce earning assets. This approach considers
banks as collectors of funds, which are then intermediated into loans and other assets. Because this approach takes into
account the overall costs of banking, i.e., both operating and interest costs, it is the more suitable approach in dealing with
concerns regarding the economic viability of banks, as in this study.
The dependent variable is the total costs, ln TC, which are the sum of operating and financial expenses. Three output
quantities are included: total loans (Y1), securities (Y2), and contingent accounts (Y3)6. The three input prices include wage
rate (W1) measured by the ratio of personnel expenses to total assets, as data on the number of employees are not available;
price of physical capital (W2), defined as the ratio of occupancy expenses to the book value of fixed assets; and price of funds
(W3), measured as the ratio of total interest expenses to total funds. In imposing linear homogeneity, the price of funds is
used to normalize total costs and the other input prices.

4.2. Potential correlates of inefficiency

4.2.1. Bank regulation and supervision

To examine the impact of Basel II on the efficiency of the banks, the three pillars are included in the estimation: (1) capital
regulation; (2) official supervisory power; and (3) private monitoring. The proxies for regulation and supervision variables
are constructed following Barth et al. (2004, 2006)7.
The bank capital regulation index, which is the proxy for pillar 1, includes both initial and overall capital stringency. Initial
capital stringency measures the extent of regulatory requirements regarding the amount of capital that banks must have
relative to specific guidelines while overall capital stringency measures the extent to which the source of funds that count as
regulatory capital can include assets other than cash or government securities, borrowed funds, and whether the sources of
capital are verified by the regulatory or supervisory authorities. Therefore, the index captures both the amount of capital and
verifiable sources of capital that a bank required to possess. It is calculated on the basis of 9 questions and ranges in value
from 0 to 9, with a higher value indicating greater stringency.
The official supervisory power index, which is a proxy for pillar 2, measures the extent to which official supervisory
authorities have the authority to take specific actions to prevent and correct problems. It is calculated based on 14 questions
indicating the extent to which supervisors can change the internal organizational structure of the bank and/or take specific
disciplinary action against bank management and directors, shareholders, and bank auditors.
The market discipline index, which is a proxy for pillar 3, measures the degree to which private sector monitoring of banks
influences bank performance and fragility. It takes the value between 0 and 8 with higher values indicating higher disclosure
requirements and more incentives to increase private monitoring.
Theory provides explanations to different approaches to bank supervision8. The official supervision approach states that
official supervisors have the capabilities to avoid market failure by directly overseeing, regulating, and disciplining banks.

6
Aside from the including traditionally defined outputs, this paper includes contingent accounts as output variable, which serves as a proxy for other
services offered by banks. The contingent account of banks, although considered as technically non-earning assets of the banks, is becoming a growing
source of income for banks and thus, if excluded, total output would tend to be understated (Jagtiani & Khanthavit, 1996). In a Philippine study, Lamberte
(1982) included contingent accounts as one of the inputs in a multi-product joint cost function of banks and found a monotonically declining marginal cost
curve for this variable, indicating possible cost advantages by banks from expanding the volume of their output.
7
See Appendix for details on calculation of the variables. See also Barth et al. (2006) for information on the data, sources, and specific survey questions
used to construct the variables for this paper.
8
For detailed discussions of these two approaches, see Barth et al. (2004) and Levine (2005).
 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85 77

However, Barth et al. (2006) mention that having powerful government regulators and supervisors may also result to
corruption and impede bank operation and thus, will not improve bank performance and stability. Specifically, the authors’
empirical results show that there is no strong association between bank development and performance and official
supervisory power. In a related study, Barth, Caprio, and Levine (2003), however, show that official government power is
harmful to bank development in countries with closed political systems.
On the other hand, the private monitoring approach states that powerful supervision might be related to corruption or
other factors that impede bank operations, and regulations that promote private monitoring will result in better outcomes
for the banking sector. In practice, private monitoring of banks has been greatly encouraged by many supervisory agencies,
e.g., acquiring certified audits and/or ratings from international-rating agencies; making bank directors legally liable if
information is erroneous or misleading; requiring banks to produce accurate, comprehensive and consolidated
information on the full range of bank activities and risk-management procedures; and imposing a ‘‘no deposit insurance’’
policy by some countries (Barth et al., 2004). However, in countries with poorly-developed capital markets, accounting
standards, and legal systems, there is still great reservation in placing excessive trust in private-sector monitoring. It is
argued that such countries will benefit more from official supervisors and regulators where banks have excessive risk-
taking behavior and therefore, encouraging more confidence in depositors than from private-sector monitoring. With weak
institutional settings, increased dependence on private monitoring may lead to exploitation of small savers and thereby
much less bank development.
Several studies find that pillar 2 and pillar 3, although not necessarily mutually exclusive, reinforce each other; that is,
countries could adopt regulations that enhance both the disclosure of accurate information and the creation of powerful
supervisors (see Levine, 2005). For example, Beck, Demirguc-Kunt, and Levine (2006) argue that when market discipline is
enhanced, the corruption of bank officials will be less of a constraint on corporate finance. Moreover, Fernandez and
Gonzalez (2005) argue that a greater quality of information provided by a system that enhances private monitoring through
accounting and auditing requirements might improve the supervisors’ abilities to intervene in managerial decisions in the
right way and at the right time.

4.2.2. Risk and asset quality

To control for risk and asset quality of the commercial banks, financial capital and loan losses are incorporated in the
estimation. The ratio of provisions for loan losses to total loans is used following Mester (1996) and Altunbas, Liu, Molyneux,
and Rama (2000) to control for asset quality. In this study, it is hypothesized that an inefficient bank with high costs would
have more problem loans, so that loan loss provisioning would be positively related to higher operating costs indicating
lower cost efficient operations (Berger & DeYoung, 1997; Rao, 2005).
Meanwhile, the ratio of financial capital to total assets is included in the estimated cost function to take into account the
differences in risk preferences of banks, as suggested by Hughes and Mester (1993) and Mester (1996). Since the level of
financial capital is fundamentally linked to the bank’s risk management and risk signaling, it is hypothesized that to the
extent that well-capitalized banks reflect high quality management, these banks are more likely to be more cost efficient in
producing bank outputs by their cautious risk taking behavior (Rao, 2005).

4.2.3. Bank-specific variables and other variable

The potential correlates that controls for bank-specific features include: (1) intermediation ratio defined as the
proportion of loans to deposits, which captures the differences among domestic banks’ ability to convert deposits into loans
and reflects the developments in the legal and regulatory frameworks that support both the financial intermediation
process and lower costs to banks; (2) deposit-to-liability ratio represents the governance stance of the bank, which is based
on Jensen’s (1989) free cash flow theory that states that an appropriate policy to control agency costs is to limit free cash
flows available in order to constrain the expense preference behavior of managers by having an adequate level of debt and
strong control from the institution’s owners; and (3) a dummy variable for commercial bank type, which takes the value of
one for universal commercial banks and zero for ordinary commercial banks. Bank type and size may positively influence
efficiency levels as big banks with different functions and scope may have greater portfolio and loan diversification and
gain from size advantages (Hughes, Mester, & Moon, 2001; Yildirim & Philippatos, 2007; Altunbas, Carbo, Gardener, &
Molyneux, 2007).
In addition, a variable for the degree of asset market concentration defined as the ratio of assets of the three largest banks
to the total assets of commercial banks, which reflects either higher or lower costs for the banks, e.g., if market concentration
manifests as market power for some banks, it may lead to an increase in costs for the sector in general through inefficiency; if,
on the other hand, it manifests as market selection and consolidation through survival of more efficient banks, market
concentration may be suggestive of lower costs. Table 1 provides the summary of the definitions of the variables included in
the model along with their descriptive statistics.

4.3. Model specification

To calculate the efficiency of each individual bank in the sample, a translog cost function is used. This functional form is
popular among researchers because it allows some flexibility when estimating the frontier function. Given the variables
78 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85

Table 1
Descriptive statistics of the variables.

Variables Description Mean Standard

deviation

Dependent variable
TC Total costs: financial expenses and operating expenses (Php 10,576 10,646
millions)
Independent variables
Variable output quantities
Y1 Total loans (Php millions) 79,688 94,028
Y2 Securities: total assets less total loans and fixed capital (Php 102,277 109,207
millions)
Y3 Contingent accounts (Php millions) 101,634 187,609
Variable input prices
W1 Wage rate: ratio of personnel expenses to total assets 0.01 0.00
W2 Price of physical capital: ratio of occupancy expenses to fixed 0.29 0.20
assets
W3 Price of funds: ratio of total interest expenses to total funds 0.28 0.19
Potential correlates
Bank regulation and
supervision variables
Capital requirement Includes both initial and overall capital stringency 5.54 1.24
Official supervisory power Measures the extent to which official supervisory authorities have 11.63 0.48
the authority to take specific actions to prevent and correct
problems
Private monitoring Measures the degree to which private sector monitoring of banks 6.00 0.00
influences bank performance and fragility
Risk and asset quality variables
LLP/Total loans Ratio of loan loss provisions to total loans 0.05 0.02
Equity/Total assets Ratio of financial capital to total assets 0.13 0.04
Bank-specific variables/Other
variable
Intermediation Ratio of loans to deposits 0.59 0.21
Deposit liabilities Ratio of deposit to total liabilities 0.88 0.61
Bank type Dummy for commercial bank type: 1 = universal bank; 0.59 0.49
0 = ordinary bank
Bank concentration Ratio of assets of 3 largest commercial banks to total assets of 0.39 0.05
commercial banks

Sources of basic data: Philippine Securities and Exchange Commission, World Bank Banking Regulation Surveys.

defined above, the cost function, is specified as

  X   X      
TCit 3
y 3
w 1X 3 X 3
y y
ln ¼ b0 þ b j ln jit þ bk ln kit þ b jl ln jit ln lit
qit w3it j¼1
q it k¼1
w 3it 2 j l
qit qit
X3 X 3     X3 X 3    
1 w w 1 y w
þ b ln kit ln pit þ b ln jit ln kit (3)
2 k p kp w3it w3it 2 j k jk qit w3it
X3   X 3  
1 y w
þbq t þ br t 2 þ b jt ln jit t þ bkt ln kit t þ uit þ vit
2 j
qit k
w3it

where ln TCit is the natural logarithm of total costs of the ith bank in time t; ln yit the natural logarithm of the jth output; ln wit
the natural logarithm of the kth input price; t is the year of observation which is a proxy to capture any changes that may
have occurred during the period included in the study which are not explicitly controlled for in the model; qit is the total
assets9; and b are the coefficients to be estimated. In accordance with economic theory, costs and input prices in Eq. (3) are
normalized using one of the variable input prices (w3it) to impose linear input price homogeneity.
This study employs the Battese and Coelli (1995) model, which allows the simultaneous estimation of the stochastic cost
function and the identification of the correlates of bank inefficiencies in one-step estimation10, to incorporate the regulation

9
Following Berger and Mester (1997), Hardy and di Patti (2001) and Fu and Heffernan (2007), the cost and output terms are expressed as a ratio of total
assets, q to mitigate size-related heteroscedasticity and any potential bias arising from differences in scale.
10
This is in contrast to the two-step estimation approach (see Pitt and Lee, 1981), in which the first step involves the specification and estimation of the
stochastic frontier production function and the prediction of the technical inefficiency effects; while the second step involves the specification of the
regression model for the predicted technical inefficiency effects. But such an approach may be inconsistent in its assumptions regarding the independence
of the inefficiency effects in the two estimation stages (Coelli, 1996). See also Wang and Schmidt (2002) for further discussion on the merit of the one-step,
simultaneous estimation.
 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85 79

and supervisory variables and examine the correlates of efficiency. This approach assumes that environmental factors
directly affect technical efficiency of the banks, that all banks share the same technology represented by the production
frontier, and that the environmental factors have an influence only on the distance that separates each bank from the best
practice function (Coelli, Perelman, & Romano, 1999).
Under this one-step approach, the uit is defined as

uit ¼ zit d þ wit (4)

where uit follows a truncated-normal distribution with mean zitd and variance s 2u ; zit is a vector of explanatory variables, i.e.,
risk and quality variables and bank-specific variables that may influence the efficiency of the banks; d is a vector of
parameters to be estimated; and wit is defined by the truncation of the normal distribution N(0, s2), such that the point of
truncation is zits, i.e., Wit   zitd.
It is to note that the frontier model (Eqs. (3) and (4)) accounts for both technical change and time-varying inefficiency
effects. To account for non-neutral technical change, the stochastic frontier (Eq. (3)) has the time trend, t, interacted with
the input variables while a time-squared variable was included to allow for non-monotonic technical change (Coelli, Rao, &
Battese, 2005). The overall cost efficiency of production for the ith bank at the tth year of observations is the ratio of the
stochastic frontier input cost used to the observed input used. The stochastic frontier input cost use is defined by the value
of input cost use if the cost inefficiency effect, uit, was zero, i.e., the bank was fully efficient in the use of input. Given the
specifications of the translog stochastic frontier cost function in Eqs. (3) and (4), the cost efficiency of a bank can be
expressed as

CEit ¼ expðuit Þ (5)

which indicates that the cost efficiency is no greater than one. The prediction of the cost inefficiencies is based on conditional
expectations which generalize the estimators computed in Jondrow, Lovell, Materov, and Schmidt (1982) and Battese and
Coelli (1988, 1993)11.
Eqs. (3) and (4) are estimated simultaneously using the Maximum Likelihood (ML) approach using the computer
program, Frontier Version 4.1 by Coelli (1996). The program estimates the parameters of the model using the
   
parameterization of Battese and Corra (1977) with s 2 ¼ s 2v þ s 2u and g ¼ s 2u = s 2v þ s 2u :

5. Empirical results

5.1. Tests of hypothesis

The results using the generalized likelihood-ratio (LR) tests in evaluating hypotheses for the sufficiency of representation
of the cost structure of the banks in the sample are shown in Table 2. The first null hypothesis (H0: m = 0), which states that
the technical inefficiency effects have a half-normal distribution, is strongly rejected. The second null hypothesis (H0: g = 0),
which specifies that the inefficiency effects are absent from the model, is strongly rejected, suggesting that the inefficiency
component needs to be incorporated in the model and that an average cost function is not an adequate representation of the
data. The third hypothesis (H0: d1 = . . . = d9 = 0) specifies that the inefficiency effects are not a linear function of the bank and
regulation, risk and asset quality, and other bank-specific variables, and therefore have no significant impact on the cost
structure of the commercial banks. This hypothesis is strongly rejected, indicating that these variables are useful in
describing the cost inefficiencies of the banks. The last hypothesis specifies that the interaction term of no technical change
(H0: b3 = bi3 = 0, i = 1; 2; 3) is rejected, indicating that technological change exists in the commercial banking sector. Given
the specifications of the translog stochastic cost frontier function model, the results from the tests of hypotheses suggest that
a simpler model like ordinary least squares (OLS) cannot adequately specify the cost inefficiency of commercial banks in the
country.

5.2. Properties of cost inefficiency

The overall mean cost efficiency estimate for the period 2001–2011 is 0.75. This result indicates that, on average, 25% of
the commercial banks’ costs are wasted relative to the best-practice commercial bank within the sample producing the same
output and facing the same conditions. The cross-sectional distribution of cost efficiency estimates of the commercial banks,
which provides rankings of the banks, suggests that the most efficient bank in the sample could still be operating with a
moderate level of inefficiency.
Fig. 1 presents the average measured cost efficiency of all commercial banks from 2001 to 2011. The early 2000s is
characterized by an improving cost efficiency, followed by a slight drop in efficiency in 2005 which could be attributed to
regulatory tightening such as the phased-in implementation of the modified local capital adequacy framework in

 0   0   0   0 
11
It is to note that d zit þ wit > d zi0 t þ wi0 t for i 6¼ i0 does not necessarily imply that d zit0 þ wit0 > d zi0 t0 þ wi0 t0 for t 6¼ t 0 : It follows then that the
same ordering of banks in terms of cost inefficiency of production does not apply to all time periods.
80 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85

Table 2
Tests of hypothesis.

Null hypothesis LR Critical value* Decision

Test for half-normal functional form: H0: m = 0 46.42 23.21 Reject H0

Test of no inefficiency effects: H0: g = 0 177.59 20.97** Reject H0
Test of potential correlates: H0: d1 =  = d9 = 0 32.87 11.34 Reject H0
Test of no technical change over time: H0: b3 = bi3 = 0, i = 1,2,3 21.12 13.28 Reject H0

Source: Author’s calculation.

* All are statistically significant at the 1% level.
** Obtained from Table 1 of Kodde and Palm (1986) because g = 0 is on the boundary of the parameter space and the asymptotic distribution of the
generalized likelihood ration statistic is a mixed Chi-square distribution.

preparation for the full implementation of Basel II in 2007; adoption of new accounting and financial reporting standards;
and preparation for internal rating-based approach for full implementation in 2010 (BSP, 2005). In addition, the system is
still saddled with a continuing overhang of bad assets and the costs associated with asset cleanup (BSP, 2005).
After 2005, an improvement in the cost efficiency of the banks can be observed. Several factors can explain this
improvement in the efficiency of the banks. For one, the asset quality of the banking system has remarkably improved. With
the implementation of Basel II in July 2007, banks’ capital became more risk-sensitive in line with international standards
and remained well above the minimum BSP regulatory requirement of 10% and the international benchmark of 8%. Even with
the onset of the global financial crisis in 2008, the banks efficiency remained cost efficient partly because of the earlier
reforms implemented by the BSP particularly on overall risk management of banks and the much-needed cushion provided
by banks’ sustained profitability in the past. As Kawai (2009) and Guinigundo (2009) have pointed out, the overall
performance of the banking system in the Asian region reflects the improvements in risk management since the Asian crisis
of 1997–1998 and the lessons learned from that crisis have served the region well in the global financial crisis.
However, starting in 2009, a decline in efficiency can be observed, which could be attributed to the global financial crisis.
Although the direct damage of the global financial crisis to the financial sector in Asia, in general, and the Philippines, in
particular, has been much less than in the US and Europe, such a result suggests that external shocks can affect the
commercial banks’ measured efficiencies. As a result, the operating costs of the banks may have increased in compliance
with more stringent structural reforms and policies imposed by the monetary authorities to strengthen the banking system
in the aftermath of the global crisis. For example, the BSP issued new rules and regulations that address the assessment of
banks’ risk exposures to US and European bank debts as well as strengthening the banks’ capital needs as a buffer to any
adverse shocks to the stability of the banking system. Also, in 2011, the BSP implemented certain provisions of Basel III for
determining capital instruments that can be counted as regulatory capital by Philippine banks from January 2011 onwards.
Moreover, the costs can be attributed to higher funding costs due to the volatility in the global credit markets. In a report by
the Institute of International Finance in October 2009 (Guinigundo, 2009), new regulations requiring banks to hold high-risk-
based levels of capital were expected to prod international banks to retrench from emerging market lending. In general, all
these costs are likely to be positively related to the operating expenses of the commercial banks.

[(Fig._1)TD$IG]
0.90

0.85

0.84
0.80
0.80

0.75 0.77 0.77

0.76
0.75
0.74
0.70 0.71
0.71 0.71
0.69
0.65

0.60
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Fig. 1. Cost efficiency estimates, 2001–2011. Source: Author’s calculation.

 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85 81

Table 3
Correlates of cost inefficiency.

Variable Coefficient Std error

Bank regulation and supervision

Capital requirement 0.1445** 0.0651
Official supervisory power 0.3348** 0.1489
Market discipline 0.4461 0.2954

Risk and asset quality

Loan loss provision 2.3583** 0.9377
Financial capital 0.0553** 0.0317

Bank-specific/other
Intermediation ratio 0.4552*** 0.0961
Deposit liabilities 0.0741** 0.0289
Bank type 0.1297* 0.0685
Bank concentration 0.6860*** 0.2622

Source: Author’s calculation.

*** statistically significant at the 1% level.
** Statistically significant at the 5% level.
* Statistically significant at the 10% level.

Overall, the performance of the banks suggests the regulatory changes continuously implemented by the government to
strengthen the banks and lessen the impact of the external shocks to the economy. It is expected that implementing
regulations is likely to increase operational costs and thus, decrease banks’ cost efficiency. It is to note, however, that this
decrease in efficiency that started in 2009 is lower than the early 2000s level where banks were struggling with higher bad
loans.

5.3. Potential correlates of cost efficiency

Table 3 shows the results from the maximum likelihood estimation that relate the measures of cost inefficiency to
potential correlates12. In the absence of a theoretical rationale for determinants of the efficiency of the banks, these
correlates, which are at least partially exogenous, are generally considered in the current literature as potential sources of
inefficiency among banks. While the results are suggestive, they should be interpreted with caution13.

5.3.1. Bank regulation and supervision

The first pillar of Basel II, capital requirement, has a significant negative effect on measured cost inefficiency,
indicating that an increase in capital requirements of banks tends to improve their cost efficiency. This finding, which is
consistent with the study of Thangavelu and Findlay (2011) on Southeast Asian banks, suggests that banks might
experience better risk management if they assume greater ownership of their activities, which is in line with the recent
recommendation by the Basel II Accord to increase capital requirements to manage the risk-taking activities of banks (BIS,
2006). Moreover, as explained by Berger and Bonaccorsi di Patti (2006), higher capital requirements could lead to higher
levels of equity capital that could lower the probability of financial distress, which decreases the need for costly risk
management activities.
Supervisory power, the second pillar or Basel II, is statistically significant and positively correlated with bank’s cost
inefficiency, suggesting that more powerful supervisors can adversely affect the efficiency of the banks. Consistent with the
previous studies of Barth et al. (2002, 2004, 2008, 2012) and Caprio, Laeven, and Levine (2007), this result suggests that
empowering direct official supervision does not improve bank efficiency. In this respect, this finding supports the private
interest approach to bank regulation and supervision (see Barth et al., 2006) that argues that governments with powerful
supervisors may use this power to benefit favored constituents or their own private welfare, which in turn results in
inefficient banking institutions and overcoming market failures. It is to note, however, that a follow-up study should be
conducted in evaluating the effect of supervisory power since the coverage of this study with respect to this pillar is very
limited14.
The third pillar, market discipline, is negatively correlated to cost inefficiency but statistically insignificant in explaining
the inefficiency of the banks. This finding suggests that there is still a need to strengthen and enhance corporate governance

12
It is to note that the quantity actually computed in Frontier 4.1 is the reciprocal of Eq. (5) and can be interpreted as a measure of the cost inefficiency of
individual banks.
13
As Mester (1996, 1997) suggested, the results simply provide information on the correlation between inefficiency and various indicators included in the
study. Moreover, due to possible endogeneity, the relationship need not imply causality.
14
Pillar 2 took effect only in January 2011 and this study covers 2001–2011.
82 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85

Table 4
Correlation between cost inefficiency and standard accounting ratios.

Variable Cost inefficiency Cost/TA ROA ROE NII

Cost inefficiency 1.00

Cost/TA 0.83*** 1.00
ROA 0.68*** 0.56* 1.00
ROE 0.97*** 0.56* 0.98*** 1.0
NII 0.57* 0.60* 0.31 0.43 1.00

Source: Author’s calculation.

*** Statistically significant at the 1% level.
* Statistically significant at the 10% level.

and private sector monitoring of the financial markets in the country to reduce corruption and ambiguity in bank lending and
improve the functioning of the banks as true financial intermediaries. As noted by Thangavelu and Findlay (2010), the more
developed and well-diversified financial markets will rely heavily on the private sector to provide information on the
activities of the banks for depositors and potential investors; however, given the stage of growth of the financial markets in
Southeast Asia and developing countries, private monitoring might not produce a positive impact in these countries as
compared to those hosting well-developed financial markets. Interestingly, as in the case of the Philippines, Barth et al.
(2012) noted from the series of surveys that many more countries were increasing capital requirements from 1999 to 2009,
whereas there is no marked difference in the increase or decrease of supervisory powers and slightly fewer countries
increasing private monitoring compared with those decreasing it.

5.3.2. Risk and asset quality

Loan loss provision is statistically significant and is consistent with a priori expectations that it is positively correlated
with bank’s inefficiency (Altunbas, Liu, Molyneux, & Rama, 2000; Berger & DeYoung, 1997; Girardone, Molyneux, &
Gardener, 2004). An inefficient bank with high costs would have more problem loans so that loan loss provisioning, as a
proxy for loan quality, would be positively related to higher operating costs.
Financial capital, which captures capital risk and the risk preference of a bank’s management, has a significant negative
effect on measured cost inefficiency. Consistent with the findings of Mester (1996) and Girardone et al. (2004), this suggest
that to the extent that well-capitalized banks reflect high quality and better risk management, these banks are likely to be
more cost efficient in producing banking outputs.

5.3.3. Bank-specific characteristics/other variable

For bank-specific characteristics, the intermediation ratio has a significant and positive effect on measured cost
inefficiency, indicating that a higher ratio increases the costs of the banks. This suggests that the financial intermediation
process among domestic banks is still costly and inefficient. The deposit to liabilities ratio has a significant and negative
effect on measured cost inefficiency, suggesting that a higher ratio curtails the expense preference of bank managers. Among
commercial banks, the results seem to indicate that universal commercial banks are more cost efficient than ordinary
commercial banks, suggesting that universal commercial banks are able to have greater portfolio and loan diversification and
gain from size advantages. For the additional variable used, bank concentration is positive and statistically significant,
suggesting that market concentration manifests as market power for some banks, thus leading to an increase in costs for the
sector in general through inefficiency.

5.4. Robustness check

To check the robustness of the results, this study follows Bauer, Berger, Ferrier, and Humphrey (1998), who argue that, in
order to make sure that the frontier measures are not simply artificial products of assumptions made regarding underlying
optimization concepts and frontier methodology, efficiency measures should be correlated (with the expected signs) with
nonfrontier measures of performance generally used by regulators and financial institutions managers.
The raw measure of cost efficiency includes the ratio of total costs to total assets of banks (Cost/TA) while the measures of
profitability include return on assets (ROA), return on equity (ROE), and ratio of net interest income to average interest
earning assets (NII). It is expected that the bank cost inefficiency levels would be positively correlated with the cost ratio and
negatively correlated with profitability measures. The results show that that these efficiencies are significant in the expected
way with the standard, nonfrontier measures of performance (Table 4).

6. Conclusion and policy implications

Although many countries have followed the Basel guidelines, existing evidence on the positive impact of Basel II on
bank efficiency is at best mixed. Given that the banking supervisors in the Philippines strongly advocate the
implementation of Basel guidelines and yet, existing studies is still relatively scarce, focusing on this concern is long
 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85 83

overdue. Thus, this paper attempts to fill the gap in banking regulations and bank performance studies as it focuses on the
analysis on Basel II and bank efficiency from a developing country perspective. Using stochastic frontier analysis, this
paper has examined the impact of Basel II on the cost efficiency of Philippine commercial banks from 2001 to 2011. The
empirical findings show that the overall mean cost efficiency estimate is 0.75, indicating substantial inefficiencies in the
banks averaging to 25% of total costs.
Findings show that higher capital requirement tends to improve the cost efficiency but more powerful supervisors can
adversely affect the efficiency of the banks. However, market discipline is not significant in explaining bank efficiency. On
capital requirements, the finding suggests that banks might experience better risk management if they assume greater
ownership of their activities, which is in line with the recent recommendation by the Basel II Accord to increase capital
requirements to manage the risk-taking activities of banks. On supervisory powers, the finding supports the private interest
approach to bank regulation and supervision (see Barth et al., 2006) that argues that governments with powerful supervisors
may use this power to benefit favored constituents or their own private welfare, which in turn results in inefficient banking
institutions and overcoming market failures. Lastly, since market discipline is not significant suggests that there is still a
need to strengthen and enhance corporate governance and private sector monitoring of the financial markets in the country
to reduce corruption and ambiguity in bank lending and improve the functioning of the banks as true financial
intermediaries.
The other potential correlates that may help explain the cost efficiency of the banks are loan loss provision and financial
capital, suggesting that higher cost efficiency is expected to be correlated with better credit risk evaluation and banks with
less risky assets and well-capitalized banks are performing better. In addition, cost inefficiency seems to be strongly related
to intermediation ratio and deposit liabilities ratio. Among commercial banks, the results seem to indicate that universal
commercial banks are more cost efficient than ordinary commercial banks.
From a policy perspective, this study is informative to policymakers on the general direction in which to proceed with
reforms (i.e., maintain higher capital requirements, curtail powerful supervisors, and enhance private monitoring) to
improve and strengthen the country’s commercial banks as well as in identifying factors that could contribute to their
efficiency. In light of the implementation of Basel III regulations in the country, it is imperative to know whether the Basel
regulations have positive impact on the efficiency of commercial banks. In effect, this paper also assesses the readiness of the
commercial banks toward the implementation of Basel III in the country.

Appendix A

Variable Description

Capital requirement
Official supervisory power
Private monitoring
This variable takes values between 0 and 9, with higher values indicating grater stringency. It is determined by
adding 1 if the answer is yes to questions 1–7 and 0 otherwise, while the opposite occurs in the case of questions 8
and 9 (i.e. yes = 0, no = 1). (1) Is the minimum required capital asset ratio risk-weighted in line with Basle guidelines?
(2) Does the ratio vary with individual bank’s credit risk? (3) Does the ratio vary with market risk? (4–6) Before
minimum capital adequacy is determined, which of the following are deducted from the book value of capital: (a)
market value of loan losses not realized in accounting books? (b) unrealized losses in securities portfolios? (c)
unrealized foreign exchange losses? (7) Are the sources of funds to be used as capital verified by the regulatory/
supervisory authorities? (8) Can the initial or subsequent injections of capital be done with assets other than cash or
government securities? (9) Can initial disbursement of capital be done with borrowed funds?
This variable takes values between 0 and 14, with higher values indicating higher power of the supervisory
authorities. It is determined by adding 1 if the answer is yes and 0 otherwise, for each one of the following 14
questions: (1) Can supervisors meet external auditors to discuss report without bank approval? (2) Are auditors
legally required to report misconduct by managers/directors to supervisory agency? (3) Can legal action against
external auditors be taken by supervisor for negligence? (4) Can supervisors force banks to change internal
organizational structure? (5) Are off-balance sheet items disclosed to supervisors? (6) Can the supervisory agency
order directors/management to constitute provisions to cover actual/potential losses? (7) Can the supervisory
agency suspend director’s decision to distribute: dividends? (8) bonuses? (9) management fees? (10) Can the
supervisory agency supercede bank shareholder rights and declare bank insolvent? (11) Does banking law allow
supervisory agency to suspend some or all ownership rights of a problem bank? (12) Regarding bank restructuring &
reorganization, can supervisory agency or any other govt. agency do the following: supercede shareholder rights?
(13) remove and replace management? (14) remove and replace directors?
This variable takes values between 0 and 8, with higher values indicating policies that promote private monitoring. It
is determined by adding 1 if the answer is yes and 0 otherwise, for each one of the following 8 questions: (1) Is
subordinated debt allowable (required) as part of capital? (2) Are consolidated accounts covering bank and any non-
bank financial subsidiaries required? (3) Are off-balance sheet items disclosed to public? (4) Must banks disclose risk
management procedures to public? (5) Are directors legally liable for erroneous/misleading information? (6) Do
regulations require credit ratings for commercial banks? (7) Does income statement contain accrued but unpaid
interest/principal while loan is non-performing? (8) Is there an explicit deposit insurance scheme?

Source: Barth et al. (2001, 2006).

84 M.C.V. Manlagnit / Journal of Asian Economics 39 (2015) 72–85

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