1. Reforming Development Banks: A Framework Augusto de la Torre Senior Regional Advisor World Bank Public Sector Banks and Privatization World Bank Workshop Washington. D.C. 10 December 2002

2. 2 Agenda u The problem: under-served sectors’ access to financial services u Traditional response: establish a development bank u Public sector banks n The hard evidence n Parcial solutions n The inherent contradiction u Public sector bank reform – guiding principles u The role of public policy n The enabling environment n What to do with development banks? n Sustainable broadening of access to financial services  Examples of financial market promotion u Final remarks

3. 3 The Problem: Underserved Sectors’ Access to Financial Services u Risks n High, often correlated, and complex – particularly in small farming  Low and volatile incomes n Substantial agency and information asymmetry problems  Screening and monitoring challenges in the absence of reliable financial statements and planning  Weaknesses in enforceability of property and creditor rights Limitations in the use of collateral, particularly movable u Crowding out (lending to government option) n Reduces appeal of higher return/higher risk combinations u Macro-systemic voltility n Raises liquidity premium, limiting credit in general

4. 4 Traditional Response: Establish a (Public) Development Bank u Perception that private financial entities are inherently uninterested in the under-served n Small farmers, low income families, SMEs, and micro- enterprises u State takes the “bull by the horns” to correct this perceive “market failure” via the creation of public banks n Long-duration finance in national currency as a key missing market u Emphasis is on credit provision and direct State involvement in the sector (R&D, investments, etc.)

5. 5 State Ownership of Banks: Declining but Still Substantial (Caprio et. al 2000) Share of the assets of the top 10 banks owned or controlled by the government 0 20 40 60 197019851995 Developed countries Developing countries

6. 6 State Ownership of Banks, 1998: Popularity is International (Caprio et. al 2000) 25% - 50% 0 - 10% 10% - 25% N.A. 75% - 100% 50% - 75%

7. 7 Public Sector Banks – The Hard Evidence u Greater participation of State in bank ownership leads to (Caprio et al. 2000): n Less financial sector development, less growth, and lower productivity n Greater financial intermediation spreads n Less credit to the private sector n Grater concentration of credit n Some propensity to crises (weaker monitoring) n Recurrent fiscal drains

8. 8 Public Sector Bank Reform – Partial Solutions u Improve governance n More professional directors and administrators n Shields against exesive politial interference n Stricter accountability and greater transparency u Improve regulation and supervisory enforcement n Leveling the playing field vis-a-vis private banks u Abandon first-tier banking, but not second-tier function n Private banks evaluate and take on risks n Second-tier bank evaluates and controls exposure to risk of private banks

9. 9 Public Sector Banks – Inherent Contradiction: Activities versus Social Policy Mandate u The Sisyphus syndrome n Social policy mandate n => concentration on high risk/ low return activities n => systematic losses and recurrent recapitalizations n => improvements in governance and supervision n => re-orientation towards profitable activities, in direct competition with private banks n => insufficient attention to social policy mandate n => political pressures to implement social policy mandate u Neither governance/supervision improvements, nor shift towards second-tier banking eliminate the Sisyphus syndrome

10. 10 ( 1 ) Reduce, simplify, and re- define the role of the State in financial markets Guiding Principles for Public Sector Bank Reform Exit first-tier banking Promote financial market development via well- designed instruments (incl. Subsidies) Some second-tier credit activity (subject to adequate governance and accountability) Modernize the enabling environment Role of State Transfer programs for the non-bankable poor

11. 11 Guiding Principles for Public Sector Bank Reform (cont.) ( 2 ) ( 3 ) Avoid major disruption of credit flows during the transition Avoid a “central planning” approach to reform Anticipate credit flow reductions as result of reform Adopt compensating measures Set up a process that allows for: Competition and choice Learning, discovery, innovation Mistakes – without exesive shifting of risks and costs to the government

12. 12 Public Policy – The Enabling Environment u Market-friendly regulatory and supervisory framework u Financial market infrastructure – to reduce costs of screening, monitoring and enforcement n Information on debtors n Accounting and disclosure standards n Contractual environment: quality, diversity, enforcement  Movable collateral  Shareholder and creditor rights, including in corproate insolvency proceedings u Extreme (unrealistic) option – let the market do the rest

13. 13 Public Policy – What to do with Public Sector Banks? u Radical solution – separate the terms of the contradiction n Development bank without social policy mandate = private bank n Social policy mandate without a bank => vehicle? u Intermediate solution n Emphasize the promotion of financial market development n With limited second-tier lending activity (long-term finance; finance for investment at local government level)  Note: some traditional second-tier lending activities cannot compete under financial globalization (e.g., export finance)

14. 14 Public Policy – Sustainable Broadening of Access to Financial Services u A function of a “development agency”(DA) – not a bank u What is a DA? n Flexible vehicle for focused public policy n Operates principally with budgeted fiscal transfers n Its priorities are determined and scrutinized by Congress within the budgetary process n Own evaluation criteria – e.g., benefits per unit of subsidy, subject to promotion of financial markets n May or may not include risk taking n Can be part of a second-tier development bank

15. 15 Promotion of Financial Market Development Examples of Instruments Criteria: Align Incentives Increase availability of information, strengthen demand, widen options, do not distort relative prices, lower transaction costs u Matching grants (transitory) u Grouping debtors (collateral; collective monitoring) u “Brokerage” – information, financial services, etc. u Direct subsidies (declining, transitory) for investment  Adoption of new loan technologies  Professional services networks u Creation of market infrastructures  E.g., NAFIN’s system for discounting receivables of SMEs u Partial guarantees (transitory risk sharing)

16. 16 Final Remarks u The re-definition of the role of the State tends to lack behind fast-paced change in financial markets u Segmentation of access to financial services could deepen with financial globalization u A sole emphasis on the enabling environment appears insufficient for public policy u The are potentially constructive roles for some functions of development banks and development agencies u “Better practices” emerging but there is no simple recipe