Benefits and Costs of Privatization of State-Owned Banks Lessons for Development Banks

1. Benefits and Costs of Privatization of State-Owned BanksLessons for Development Banks Lemma W. Senbet University of Maryland UN Ad Hoc Expert Group Meeting “Rethinking the Role of National Development Banks” New York, December 1-2, 2005

2. Bank PrivatizationsRelevance to Development Banks • In the wake of extensive financial sector reforms and financial globalization, development banks are being increasingly privatized. • While development is still central to the agenda of development banks, they are, nonetheless, expected to maintain their financial viability in terms of asset quality, profitability, and efficiency. • Commercial banks do also foster development. Growing evidence for positive linkage between banking development and economic development. Privatization experiences of these banks relevant to development banks. • Yet, development gap due to financing gap to be bridged

3. Background • Continuing debate on bank privatizations • Pro-privatization reformers • Resisters to privatization; at the extreme even hostile to privatization of finance altogether • Pro and anti privatization experience of Africa – a region of highly volatile economics and politics • Privatization reformist experiments without getting underlying governance and incentives right (e.g. Nigeria) • Extreme resisters, even hostile to privatization of finance altogether (e.g., Ethiopia) • The available evidence is mixed depending on the developing regions (say Latin America versus Africa) • Both reformers and resisters are reassured!

4. Resistance to Bank PrivatizationIllustration: Ethiopia • 100% government ownership of the Commercial Bank of Ethiopia (CBE) • Gradual and encouraging entry of private banks • But the CBE has a lion’s share of the banking market • Private banks are not only just small but 100% domestically owned • No foreign ownership in the financial sector, including insurance market; nor is new foreign entry allowed in the financial sector • No stock market • Hence, no market-based privatizations; no basis for financial cooperation and integration with other emerging economies in Africa • Thus, no privatization of finance in Ethiopia. Just a command financial economy!

5. Conceptual Framework: Multiple Functions of a Financial System • The firm as a nexus of contracts (Figure 1) • Mobilization of domestic financial resources • Risk sharing and risk diversification • Information production and price discovery • Promotion of corporate governance • Mobilization of global capital and promotion of financial globalization • Summing up: Mere existence of banks and stock markets – value?

6. Management Outside (New) Equity holders Firm Other Stakeholders (Product and Factor Market) Government/ Society Debt holders Classes of Agency Excessive Perquisites Underinvestment Overinvestment Risk Shifting Asymmetric Information Bankruptcy and Financial Distress Management Debt holders, Stakeholders Government/Society Debt holders, Government New Equity holders Debt holders, Stakeholders The Public Firm: A Network of Contracts

7. Potential Benefits of Bank Privatization • The government (politicians and bureaucrats) is not a benevolent social guardian • State-owned banks can be used for political and personal gains • Privatization improves bank governance • Privatization improves bank competition • Privatization improves bank efficiency and performance; and fosters stability

8. Potential Costs of Bank Privatization • Private banks shun underserved markets (e.g., rural sectors) • Private banks engage in excessive risk lending and hence engender banking crisis and instability • Private banks provide insufficient but concentrated lending if the banking sector is concentrated post-privatization • Borrowers with informational and contractual difficulties are rationed out by private banks

9. Bank Privatization and Performance Available Evidence • There has been sharp decline in the state ownership of banks, particularly in low income countries (Cull, et al, World Bank Data) • The available evidence is primarily on bank performance and efficiency • Post-privatization profitability versus pre—privatization and private banks (Performance) • Cost reductions (Efficiency) • Factors affecting performance (e.g., governance, regulation, competition)

10. Government Holdings of Bank Assets Source: George Clark, Robert Cull, Mary Shirley (2004)

11. Available Evidence(contd) • Recent studies based on World Bank project • Performance effects of privatizations vary across countries. • In most cases, performance improved. • Cost efficiency improved less than measures of profitability (e.g., ROE.) • Performance gains were smaller when governments retained partial ownership. • Greater gains when bought by strategic investors. • Greater gains with more foreign participation.

12. Bank Privatization and PerformanceAfrican Experience • Widespread privatization of banks in Sub-Saharan Africa in the wake of financial sector reforms • Africa experienced the sharpest decline in state ownership during the 1999-2002 period (see earlier charts) • Otchere and Senbet, 2005; Based on World Bank Privatization database and supplemental appendix to Megginson (2000) • Are they gains from African privatizations? (see tables)

13. Gains from African Bank Privatizations? • Measures of performance looked at: • Asset quality, profitability, cost efficiency, etc. • There was deterioration in asset quality. • Profitability worsened post privatization. • No significant improvement in efficiency. • Privatized banks experienced negative abnormal returns. • Possible factors • share issue privatizations and partial privatizations

14. Table 7 Bank Privatization and Performance Operating performance of Privatized Banks in Africa This table contains the median operating performance measures for the sample firms the operating performance measures analyzed include Asset quality, Management efficiency, Earnings ability and Labor (employment levels and labor productivity). The z-statistics for the Wilcoxon signed rank test of the difference in median ratios between the two samples are presented in Panel C. The median ratios and z-statistics are reported where enough observations exist to compute the z-statistic. Panel A: Asset Quality Ratios: Panel B: Profitability Return on Assets (ROA) Return on Equity (ROE)

15. Bank Privatization and Performance: Africa (Senbet and Otchere, 2005) Operating performance of Privatized Banks in Africa This table contains the median operating performance measures for the sample firms the operating performance measures analyzed include Asset quality, Management efficiency, Earnings ability and Labor (employment levels and labor productivity). The z-statistics for the Wilcoxon signed rank test of the difference in median ratios between the two samples are presented in Panel C. The median ratios and z-statistics are reported where enough observations exist to compute the z-statistic. Panel A: Asset Quality Ratios: Panel B: Profitability Return on Assets (ROA) Return on Equity (ROE)

16. Panel C: Efficiency Panel D: Changes in Employment Results:: Asset Quality ratios:Loan loss provision has increased in the post privatization period. The privatized firms’ loan loss provision of 3.05 is significantly different from that of rival banks at 1%. Impaired assets of the privatized banks have also worsened in the post privatization period. Profitability ROA: Profitability has reduced in the post privatization period, even so the privatized banks are more profitable than rivals albeit the difference is not statistically significant. ROE of the privatized banks have also fallen. This could be due to the increase in equity following the privatization and the issue of more equity. Efficiency No perceptible change in the efficiency of the privatized firms vis-à-vis the rivals. Changes in staff levels: The privatized firms have significantly reduced their staff levels. The change in staff levels of -4.67% is significantly different from that of the rivals of 1.33% at the 1% level. Overall observation: Consistent with Otchere (2004) the privatized firms have not significantly improved upon their operating performance.

17. Challenges to African Bank Privatizations • Volatile economic and political environment • Quality of data • Measurement issues (e.g., benchmarking) • Limited measures of privatization gains (private gains versus social gains) • Bank profitability (ROE, ROA, NPL) • Cost efficiency

18. Gains from Bank Privatizations? Incomplete! • Performance and cost efficiency effects are incomplete in terms of judging the overall gains of bank privatizations (Private vs. social gains) • Lending to government vs. private sector • Non-intermediation (lending to government and non-banking activities) dominates in terms of performance • Rent-seeking and dysfunctional banking system • Thus, apparently positive performance is a reflection of malfunctioning banking system and rent-seeking behavior

19. Toward Complete Gains from Bank Privatizations • Improvements in quality of financial intermediation (notice exorbitant bank spreads in Africa) • Improvements in in capacity to manage and control risk • Improvements in bank governance • Management, compensation structure, ownership, board effectiveness • Bank privatization and stock market development • Market depth and liquidity; Pricing efficiency; Risk management • Quality of bank regulation • (Cull, Sorge, Senbet, JMCB, 2005)

20. Conclusions Lessons for Development Banks • Development banks should play a role in creating an environment for gains from bank privatizations; gains from bank privatizations are linked to economic development • Thus, an indirect role of development banks in economic development through the development of traditional financial institutions • Strengthening institutions: bankruptcy code, contract enforcement, rule of law, etc. • For share issue privatizations: get corporate governance right; concentrated ownership, yet protection of minority shareholders

21. ConclusionsLessons for Development Banks • Development banks should play a role in the development of benchmark bond markets as well as stock markets – e.g., regional integration of thin local markets – regional stock markets • Human capital and financial manpower development; also, regional synergy in skills development • Ultimately helping establish an appropriate platform for the development banks themselves to be privatized • Separating the development agenda from ownership structure; development banks need not be owned by governments