Public Sector Banks and their Transformation

1. Public Sector Banks and their Transformation James A. Hanson Sr. Advisor Operations and Policy Department, Financial Sector Vice Presidency, The World Bank

2. The opinions in this presentation and paper are solely those of the author and may not reflect the opinions of the World Bank, its Executive Directors, or the countries which they represent. Based on Bank Work led by Jerry Caprio and by Bob Cull and on a seminar last year: Transforming Public Sector Banks (available on Web Site)

3. State Banks’ Performance is Important because State Banks are Important

4. Outline of the Presentation • Why Did Public Sector Banks Develop? • The Performance of Public Sector Banks • Why has Their Performance Been Bad? • Lessons for Improving Performance: Incentives and Governance Improvements • Privatization • Other Options: Agencies, Closure, Narrow Banks

5. Why Public Sector Banks? 1. Political: power and de-colonization 2. State-Led Develop. needs State Banks Channel cheap funds to Public Sector and “friends 3. Market Failure • Lack of Credit for industry(LT), agric., SMEs, housing, (new) export • Failure to Recognize Good Clients: SMEs Farmers • (Sometimes) Offset Non-financial Distortions. 4. Takeovers after Crises

6. Performance of Public Sector Banks • A few have done well, most poorly • High NPLs • High spreads and overhead costs • Often lend mainly to public sector • Often lend to higher income clients • Cross country macro-relationships: • Less private sector credit & financial development • Less growth.

7. Why Poor Performance? • Credit Allocation differs from private banks. Different Allocation means worse results unless market really fails. • The Negative View: “[the evidence is] consistent with the political view of government ownership of firms, including banks, according to which ownership politicizes the resource allocation process and reduces efficiency.” La Porta, Lopez de Silanes, and Schliefer (2002)

8. Why Poor Performance? A More Benign View: Even well intentioned Govs. face 5 Problems • Multiple Objectives/State Intervention • Lack of Information (Pol. not Tech. Problem) • Political Problems in Setting Realistic Interest Rates and Collecting • Culture of Non-Payment • Corruption—the Iron Law of Credit Allocation

9. Transforming Public Banks:The Standard Approach • New Management • Write-off or remove bad loans • Try to reduce costs • Improve information technology and risk management Bank will be as good as private banks

10. Failure of the Standard Approach • Recaps are often Too Small More fundamentally • Doesn’t Deal with the 5 Issues. Costs are not the issue. Incentives and reducing NPLs are. • No market discipline.

11. Transforming State Banks • Eliminate government interference in lending, • Incentives for the management and staff to lend and collect well, • Information system for accountability, • Interest rates that cover costs of lending to high-risk clients, and • Eliminate the culture of borrowers’ non-payment through enforcement of contracts. • Still no market discipline.

12. Specific Suggestions • Government defines a simple objective, e.g. rapid privatization—and avoids interventions. • The new management chosen to manage • Management and staff have good incentives. • Information for timely monitoring, esp. the cost and benefits of subsidies • New lending constrained, especially large loans, to limit new non-performing loans.

13. Privatization If trying to make a state bank resemble a private bank, then why not privatize? Privatization can yield substantial gains, especially in terms of lower NPLs. In Clarke -Cull study of Argentine provincial banks, recapitalization would have cost 2-4 times as much as privatization, over time. Privatized banks appear to be more efficient, especially when privatization done to strategic, reputable international investor.

14. Privatization Is Not Easy • Governments want to keep the policy instrument • Staff and clients want to keep benefits • Political issues in sale price • Partial Privatization may cause problems • Biggest Problem: Divesture to unsound buyers or through equity market, e.g., Mexico, Africa, Czech Rep., Poland, and Hungary.

15. Making Privatization Work Better • Improve the informational and the regulatory and supervisory environments • Set a well-defined timetable for privatization • Recapitalization is probably necessary • Buyers should meet “fit and proper” test; foreigners should not be excluded Best results when sold to a reputable international bank.

16. 3 Alternatives to Privatization • Closure, Agency, Narrow Bank • All the alternatives focus on limiting new bad loans. • All have some faults/not perfect, but better/less costly than keeping the bank public and making more bad loans.

17. 3 Alternatives to PrivatizationI.Closure and Liquidation • Often used when bank culture is failure Recapitalization will bring only new NPLs • Banking is essential, a bank is not. Bad credit drives out good credit • Other banks will take up the business Sell-off parts, transfer deposits, etc. Make the rest of the system work better.

18. 3 Alternatives to PrivatizationII.Government Agency • Transparent—annual parliamentary review eliminates the non-transparent tax/subsidy system of public sector banks, and distortions created in system by state banks. • Be careful with lending, agencies can be worse than state banks in collecting.

19. 3 Alternatives to Privatization III. Turn a Bank into a Narrow Bank • Holds only Central Government Debt (and there is plenty after a recapitalization) • Provides Deposit and Payments Services • Limits New NPLs (some do micro-credits, with approach similar to private banks). • Can compete, particularly in rural areas • Beware widening of lending scope to provincial and state governments, they often don’t pay. • Eventually narrow banking may be a problem as allows too easy financing of gov. deficits.