1 Government Ownership of Banks Professor Florencio Lopez-de-Silanes International Institute for Corporate Governance Yale University "The Role of State-Owned Banks: Policy and Practice." April 26, 2004

2 Motivation.  Banks serve two important functions: provide liquidity; and mitigate information problems.  Banks are the dominant financial institution in all countries. Legal framework and informational institutions are often insufficient to support strong public capital markets. Banks benefit from a strong legal framework that supports creditor rights but are better able than public markets to survive in their absence. Banks are well suited for screening and monitoring in environments characterized by imperfect information.  Banks are very fragile. Banks throughout the world are often in financial trouble. Many of the banking crises prove very costly to resolve.

3 Banking Systems around the World  Main “Banking Models” 1.US  Glass-Steagall Act (1933)  Separation of commercial banking from underwriting 2.Germany:  Banks are widely represented on supervisory boards of industrial companies  They own shares and control the votes 3.Japan (“Main Bank”):  Frequently have the largest fraction of loans to the firms (25%)  Also large shareholders in the firms.  Discussion about what is better for other countries: There might not be a best system. 1.In most countries, the structure of the financial system is very different: oForeign Banks oState banks oBanks controlled by industrial groups 2.Corporate Governance in the form of creditor protection may be a better solution in thinking about this problem

Foreign Ownership of Banks in Latin America

5 Government Ownership of Banks & Industry Gov Banking in the 1970s soe output/gdp wb dza arg aut bgd bel bol bra chl col cri civ dnk dom ecuegy slv fra deu grc gtm hnd ind idn ita ken kor mys mex mar nga pak pan pry per phl prt sen zaf esp lkatza tha tto tun tur gbrusa ury ven

6 Government Ownership of Banks

7 GoB and Efficiency of Resource Allocation  GoB is associated wiith misallocation of resources in the economy.

8 Developing Countries  In most countries, the structure is that in fact banks controlled by industrial groups are prevalent: It was a stage in the development of financial systems of England, Japan, Russia, Scotland and the US. It is the structure in many developing countries today (Bul, Bra,Chi, Col, Ecu, HK, Ind, Kaz, Ken, Per, Phi, Rus, SA, SK, Tai, Tha, Tur, Ven, etc..) This system lends itself to Related Lending (lending by banks to persons who control or own the bank).  Some examples: The ultimate controller of over 40% of the value publicly traded firms in Latin America also controls a Bank. Even in Europe this number is as high as 28%  Most countries allow ownership of industrial and financial firms

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10 Banking Crises  Banking crises have occurred throughout history, but the magnitude of losses recently has been a departure from the past (see table on next page).  The magnitudes of banking crises in the 1980s and 1990s, in terms of number of countries, percentage of banks involved, and cost of resolution, were strikingly greater than any other period in history.  World Bank lists 112 systemic crises in the last 25 years involving 94 countries. Latin America: Argentina, Chile, Colombia, Mexico, Uruguay, Peru U.S.: Entire thrift industry collapsed in the 1980s; oMost major banks in SW, New England, Texas, and Oklahoma failed Scandinavia: Virtually every large bank in Norway, Sweden, and Finland failed or was bailed out by the government. Europe: Major banks also failed (Credit Lyonnais, Banesto, etc.) Japan: Estimates of non-performing loans reached $1 trillion.  Although, the 80s and 90s were a period of substantial prosperity unlike the Great Depression.

11 Insolvency and growth 5 years after crisis Change in average GDP growth (percent) Non- crisis countries Crisis OECD countries Crisis non- OECD countries -0.8

12 1. Strong Creditor Rights  Although over-capacity may explain a bit of the problem in financial institutions, it cannot be blamed for all the malaise in the banking sector.  A key aspect of lending is collecting: Banks need to have effective collecting mechanisms in place. These mechanisms are a result of creditor rights embedded in bankruptcy and reorganization laws in the enforcement of law.  Effective corporate governance through creditor protection has recently proven to be a key component of the development of financial systems around the world.

13 Size of Debt Markets and Creditor Protection Debt Markets/GNP Creditor Rights*Efficiency of Judiciary MEX PHL FRA PER COL PRT BRA ARG GRC TUR IRL CAN THA IDN USA AUS FINESP ITA CHL ZAF KOR BEL NOR PAK SWE JPN NDL DEU AUT DNK NZL IND MYS SGP ISR GBR

14  Financial institutions are not exempt from conflicts of interest, which in the banking jargon is sometimes called “related lending.”  Related lending occurs when a bank directs loans to parties who are somehow connected with the bank (e.g., owners, board of directors, families, friends and companies).  In some instances, related loans made by financial institutions are similar to loans made by corporations to their own board and management e.g. Adelphia in the United States.  Conflicts of interest in banking has become more significant in recent years due to bank privatizations as banks were bought and controlled by domestic industrial groups.  But the same conflicts of interest have been a problem in state owned banks. 2. Related Lending

15 Two views on Related Lending 1.Information View: RL have better terms because close ties between banks and borrowers improve efficiency.RL may improve credit efficiency: Bankers have more information about RL than UL (they are rin the BoD) Bankers use information to assess the ex-ante risk characteristics of investment projects or to force borrowers to abandon risky projects. 2.Looting View: RL have better terms to divert resources from depositors and/or minority shareholders to directors and controllers of the bank. The incentive to expropriate minority shareholders exists if the insider’s exposure to the cash flow of the firm is greater than his exposure to the profits of the bank. Deposit insurance makes looting more profitable.

16 Related Lending Episodes  Venezuela: The banking system’s collapse of resulted in estimated government losses of nearly $11 billion, equivalent to 13.5% of GDP. Banco Latino lent money under favorable terms to companies controlled by the bank’s directors and their friends. These companies were shells that siphoned cash to the personal offshore accounts of directors.  “Turkish banks taken over by the government are owed about $12 billion by customers that have defaulted on loans. Some 80% of the bad loans were those given to companies that belonged to the banks’ former owners. Many loans were transferred to the companies controlled by bank’s owners, endangering the stability of the lenders. Economy Minister said in Washington the country needs about $12 billion from international lenders… [which] will be used to inject cash into ailing banks.”—Milliyet Daily, March 28,  “Ecuador’s banking system imploded in 1998 and 1999 owing to lax supervision… The cost of the bank bailout is estimated at about 25% of GDP. The absence of vigorous regulations and effective credit policies contributed to related-party lending that destabilized the system.”—Standard & Poors, November 2000.

17 Chile: Self-loans, early 1980s

18 Value of Related Loans / Value Paid for the Bank in Privatization (Mexico)

19 Related Loans / Private Sector Loans (mean)

20 Terms of loans: Related vs. Unrelated Loans

21 Default and Recovery Rates: Related vs. Unrelated Loans

22 Conclusion  Differences in corporate governance are also a key component to understand the size, development and fragility of financial institutions. 1.Lending institutions need to be able to exercise their powers when firms cannot pay back. For this to happen, bankruptcy laws need to be strengthened and implemented to improve protection of creditors. 2.The potential conflicts of interest in BOD of banks must be reduced. Boards have allowed large-scale unprofitable related lending to occur, which has increased the fragility of the banks and the financial system. We need to prevent interested directors from voting or approving related transactions that do not benefit the institution as a whole.

23 Conclusion (2)  The challenge is more complicated for countries with poor judicial systems since simply copying laws from another system might not work. Bankruptcy reform needs to be creative and adapt to the characteristics of the judiciary system in place. The enforcement and punishment of conflicts of interest may need the help of strong regulator powers. State banks need to enter in the general banking regulation framework to gain competitiveness  Overall, the evidence points to the emergence of sounder financial systems corporate governance of banking institutions is improved in the areas of conflict of interest and effective creditor rights.