Impact of Banking Supervision Enhancement on Banking System Structure: Conclusions from Agent-Based Modeling

The Bank of Russia's policy for banking sector recovery and elimination of non-viable and unscrupulous banks from it receives experts' attention and their mixed response. Our study, in line with the key points of critique, suggests that this policy can, in the medium term, bring down the level of monopolism in the banking system and improve its efficiency, while weakening medium-sized and small banks' positions in the short term. Overall, long-term benefits from proactive supervision policy may significantly outweigh short-term losses owed to a rise in banking business concentration. To study the implications of proactive banking sector recovery we have constructed an agent-based model of the banking sector and calibrated its key variables using Russia's banking sector data. Based on the model we have compared short-term and long-term effects under two supervision regimes, one more and the other less stringent. Model estimation suggests that short-term effects of proactive supervision policy weaken the positions of medium-sized and small banks, including those complying with supervisory requirements. However, as the banking sector gains in soundness, benefits from heightened confidence in these banks and the entire banking system generally exceed short-term losses. The share of medium-sized and small banks in loans and deposits of the banking system eventually proves to be higher than prior to supervision policy enhancement. The monopolism of the banking sector declines and price competition rises. The banking system becomes a more effective economy financing institution, shedding the excessive risk to individual and systemic stability, with the average risk of financed projects remaining unchanged. Meanwhile, medium-sized and small banks' stability improves. We point out that agent-based models provide a helpful tool for studying a wide range of other issues vital to the Russian banking sector.