1. The Role of State-Owned and Development Banks Ugo Panizza October 25, 2004 Inter-American Development Bank Research Department

2. Based on: Should the Government be in the Banking Business? The Role of State-Owned and Development Banks –Eduardo Levy-Yeyati (UTDT), Alejandro Micco (IDB), Ugo Panizza (IDB) Bank Ownership and Performance –Alejandro Micco (IDB), Ugo Panizza (IDB), Monica Yanez (IDB) Bank Ownership and Lending Behavior –Alejandro Micco (IDB), Ugo Panizza (IDB)

3. Two Views Development and social views –State-owned banks can address market failures and achieve development goals Political view –Politicians create and maintain state-owned banks as a political tool aimed at maximizing their personal objectives

4. Two Views The scarcity of capital in Russia was such that no banking system could conceivably succeed in attracting funds... Supply of capital for the needs of industrialization required the compulsory machinery of the government. Gerschenkron (1962) pp. 19-22 …whatever its original objectives, state ownership tends to stunt financial sector development, thereby contributing to slower growth. The World Bank (2001) p. 123

5. Outline A Taxonomy and admission of guilt State-owned banks around the world Theory What do we know about the performance of public banks –The Micro Evidence –The Macro Evidence Conclusions

6. Outline A Taxonomy and admission of guilt State-owned banks around the world Theory What do we know about the performance of public banks –The Micro Evidence –The Macro Evidence Conclusions

7. Taxonomy Assets First-tier Second-tier Non-Banking Activities First-tier Retail banks and Hybrid Institutions (Group1) Quasi-narrow banks (Group3) Second-tier Development banks (Group 2) Development banks (Group 2) Liabilities Non-Banking Activities Development Agencies (Group 4)

8. Outline A Taxonomy and admission of guilt State-owned banks around the world Theory What do we know about the performance of public banks –The Micro Evidence –The Macro Evidence Conclusions

9. State Ownership of Banks is Widespread, Especially in Developing Countries… 0 10 20 30 40 50 60 70 80 90 100 Industrial Countries Sub-Saharan Africa Latin America East Asia and Pacific Developing Countries East and Central Europe Middle East and North Africa South Asia (%) 1970 1985 1995 Source: Own calculation based on data from La Porta et al. (2001)

10. …even after a wave of privatizations 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% Industrial Countries Sub Saharan Africa Middle East North Africa Latin America East Asia and Pacific East Europe and Central Asia South Asia 1995 1999 2002 Source: Own calculation based on data from Micco, Panizza and Yanez (2004)

11. State-Owned Banks in Latin America 020406080100 TTO PAN BOL CHL GTM SLV PER HND BRA MEX DOM ECU PRY COL VEN ARG NIC URY CRI PSB1995 PSB1970 Source: La Porta et al. (2001)

12. Can we discriminate between the two views? State-Owned banks are prevalent in –Developing countries –Countries with low financial development –Countries with poor institutions –All these characteristics are consistent with both the development and political views There is some evidence in support of the political view but only available for two countries –Italy (Sapienza, 2002) –Pakistan (Khawaja and Mian, 2004)

13. Outline A Taxonomy and admission of guilt State-owned banks around the world Theory What do we know about the performance of public banks –The Micro Evidence –The Macro Evidence Conclusions

14. Two Key Questions Should the state intervene in the banking sector? How Should the state intervene? –Regulation, Subsidy, Contracting –Direct Ownership

15. Should the state intervene in the banking sector? Arguments for state intervention 1.Maintaining the safety and soundness of the banking system 2.Mitigating market failures due to the presence of costly and asymmetric information 3.Financing socially valuable (but financially unprofitable) projects 4.Promoting financial development and giving access to competitive banking services to residents of isolated areas

16. How should the state intervene? Contracting and regulation versus direct ownership –If the characteristics of the goods or services to be produced can be fully specified by regulation or written in a contract, it will not matter whether a given good or service is directly provided by the government or contracted to a private provider

17. How should the state intervene? What if this is not the case? What if the good or service to be provided has non-contractible qualities? –Holmstrom and Milgrom (1991) show that increasing the incentives along a measurable performance reduces incentives along non-measurable dimensions –If cost reduction leads to a deterioration of the non- contractible quality private provision may have benefits in terms of cost reduction but may have costs in terms of lower quality (Hart et al., 1997)

18. How does this apply to banking? Maintaining the safety and soundness of the banking system –While the inherent fragility of the banking system is an important issue, it is not usually addressed with direct state ownership –Banking regulation and supervision together with deposit insurance should be able to reduce banking fragility without eliminating the positive incentives of private ownership. This is indeed the avenue followed by most industrial countries –However, deposit insurance and regulation do not work satisfactorily in most developing countries (Demirguc-Kunt and Detragiache, 2002, Barth et al., 2002) –Hence, in countries characterized by very low levels of institutional quality, direct state ownership has the potential to increase the trust of the public in the banking system and lead to deeper financial markets (Adrianova et al., 2002)

19. How does this apply to banking? “For what prides itself on being not only Russia's largest private bank but also its most advanced, with modernist branches and multifunctional cash machines, a run on deposits must have been a genuine indignity. On July 7th, Alfa Bank insisted for the third time in 48 hours that it was not running out of funds. It claimed that it was a victim of dirty public relations. Having survived the 1998 crisis that brought most other banks to grief, it is probably right; but many depositors (including our Moscow correspondent) took no chances… Does anyone gain? Yes: a clear winner is Sberbank, of which the state owns over 60%. It is the only bank with a full state guarantee and Russia's only widely traded banking stock. It has 64% of retail deposits.” The Economist, July 8, 2004

20. How does this apply to banking? Mitigating market failures due to the presence of costly and asymmetric information and financing socially valuable (but financially unprofitable) projects –Too little lending to certain economic sectors –This is where development banks come in –Their objectives cannot be monitored in the short run and hence there is a tension between measurable and non- measurable performance –What would make a development bank superior to grants and subsidies? Feedback between lending and research Political economy

21. How does this apply to banking? Mitigating market failures due to the presence of costly and asymmetric information and financing socially valuable (but financially unprofitable) projects –Too little lending during certain periods of time –The case for too little lending of private banks during recessions would make a case for direct state ownership (because private banks do not internalize the benefits of countercyclical lending) –The empirical evidence is mixed: Cecchetti and Krause (2001) find that PSB reduce the effectiveness of monetary policy Micco and Panizza (2004) find that lending of PSB is less procyclical than lending of private banks

22. How does this apply to banking? Giving access to competitive banking services to residents of isolated areas –This can be addressed with contracting, regulation, and subsidies Another argument for public banks: they provide an additional policy tool –They solve political economy problems and allow to do “dirty works” (clean-up of bank failures, etc.) –The costs in terms of transparency and accountability are very large

23. Outline A Taxonomy and admission of guilt State-owned banks around the world Theory What do we know about the performance of public banks –The Micro Evidence –The Macro Evidence Conclusions

24. What do we know about the performance of public banks? The Micro evidence –In developing countries, public banks are characterized by low profitability and low interest margins Profitability is particularly low in Latin America –In industrial countries, public banks are not significantly different from private banks

25. Profitability and Interest Margin Not SS Source: Micco, Panizza, and Yanez (2004)

26. Profitability of public banks

27. What do we know about the performance of public banks? In developing countries, public banks have high employment and high non-performing loans In both industrial and developing countries, public banks have high overhead costs

28. Employment, NPL, and Overheads Not SS Source: Micco, Panizza, and Yanez (2004)

29. Outline A Taxonomy and admission of guilt State-owned banks around the world Theory What do we know about the performance of public banks –The Micro evidence –The Macro Evidence Conclusions

30. The development impact of state- owned banks The findings of the most influential paper on the development role of state-owned banks are (La Porta, Lopez de Silanes, and Shleifer, 2002): –A higher share of state-owned banks leads to a smaller financial sector –A higher share of state-owned banks leads to slower growth –These findings should give a mortal blow to the development view

31. The development impact of state- owned banks However, when we try to address issues related to endogeneity, data quality, and model specification, we find that: –The relationship between state ownership of banks and subsequent financial development becomes weaker and often not statistically significant –The relationship between state ownership of banks and growth depends on the level of financial development and, in particular, becomes positive in countries with a high level of financial development –This is puzzling: state-owned banks are particularly bad where they are needed the most!!!! Countries with high financial development know how to deal with the distortions brought about by PSB The model is misspecified (omitted variable and causality between PSB and financial development)

32. The development impact of state- owned banks Further evidence –PSB do not improve allocative efficiency

33. Impact of financial development on growth of sectors that require more external financing Source: Galindo and Micco (2004)

34. Public banks do not allocate more credit to small firms Source: Galindo and Micco (2004)

35. The development impact of state- owned banks Further evidence –PSB do not improve allocative efficiency –But they seem to limit lending procyclicality

36. Bank Ownership and Credit Cyclicality Source: Micco and Panizza (2004)

37. Outline A Taxonomy and admission of guilt State-owned banks around the world Theory What do we know about the performance of public banks –The Micro evidence –The Macro Evidence Conclusions

38. Summing up There is evidence that state-owned banks: –Have fiscal costs (especially in developing countries) –Play no beneficial role in terms of growth Even though the evidence that state ownership of banks tends to stunt financial sector development, thereby contributing to slower growth (WB, 2001) is less strong than previously thought –Play no beneficial role in terms of allocative efficiency –Play a beneficial role by reducing lending procyclicality

39. Summing up From the academic point of view, the research agenda is still open We need to address causality in order to make stronger statements Studies that use micro-data and focus on development banks would be very useful

40. From the Policy Point of View Is the previous evidence sufficient to conclude that PSB should be eliminated? Not necessarily The Sisyphus syndrome (De La Torre, 2002) 1.Development mandate 2.Fiscal cost 3.Pressure to increase profitability 4.Pressure to achieve the development mandate

41. From the Policy Point of View An even more intriguing question: –Assume PSB are bad. However, they are popular with politicians. Are they so bad that international policy advisors should spend their limited political capital on this issue? Alternatively, what can be done to improve the performance of PSB? –A clear definition of the objective function and measurement of the subsidy would allow conducting true cost benefit analyses and make managers accountable –Governance structure Learn from the literature on CB independence

42. The Role of State-Owned and Development Banks Ugo Panizza October 25, 2004 Inter-American Development Bank Research Department