Abstract: It is by now commonly understood that healthy banking systems require not only more insightful regulation and supervision but a new emphasis on market discipline. In this regard a rapidly growing body of research has focused on both measures internal to the firm the bank – “corporate governance” – and other measures likely to enhance the ability of the market to work in a manner that promotes safe and sound banking practices. The current paper examines the issue of “external governance” – i.e., measures that complement good corporate governance by enhancing bank information accuracy, transparency, and accountability. In particular, using a large and new cross-country database, we develop measures of the efficacy of accounting standards, the strength of external auditing, financial statement transparency, and the efficacy of external ratings and credit monitoring activities. These measures address the issue of the extent to which those parties disclosing information to the public are held accountable for its accuracy. We incorporate these variables, as well as an index of external governance combining these components, into equations modeling various measures of bank performance, including profitability, net interest margin, and bank efficiency. We find substantial evidence that the individual aspects of external governance, as well as the composite index, have positive and statistically significant effects on bank profitability and net interest margins, and negative and statistically significant impacts on bank efficiency. Our findings suggest that subsequent research investigating cross-country differences in bank performance should directly take account of external governance factors. In addition, and more importantly, we provide empirical evidence supporting Pillar 3 of Basel II. In light of the fact that many policy decisions have been made, or are in the process of being made, based on these lessons about new ways to enhance banking safety and soundness, especially via strengthening market discipline, one might expect such empirical support to provide a measure of comfort within the banking and regulatory communities
