Should the Government be in the Banking Business? The Role of State-Owned and Development Banks

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) Public Banks in Latin America: Myths and Realities Inter-American Development Bank Research Department

Outline • Theory • What do we know about the performance of public banks? • The Micro Evidence • The Macro Evidence • Conclusions

PSB are prevalent in • Developing countries • Low financial development • Poor institutions

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

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

Two Key Questions • Should the state intervene in the banking sector? • How should the state intervene? • Regulation, Subsidy, Contracting • Direct ownership

Should the state intervene in the banking sector? • Maintaining the safety and soundness of the banking system • Mitigating market failures that lead to under-provision of banking services, during given periods of time, or to certain economic sectors • Giving access to banking services to residents of isolated areas

How should the state intervene?

1. Safety and Soundness • Banking regulation and supervision together with deposit insurance can reduce bank fragility • This is indeed the avenue followed by most industrial countries • However, deposit insurance and regulation do not work well in some developing countries • 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)

2&3 Too little lending to isolated areas, certain economic sectors and periods of time • If the characteristics of the goods or services to be produced can be fully specified, incentives are the same • With non-contractible qualities, increasing the incentives along a measurable dimension reduces incentives along non-measurable dimensions (Holmstrom and Milgrom 1991) • If cost reduction leads to a deterioration of the non-contractible quality, private provision may lead to lower quality (Hart et al. 1997)

Too little lending to isolated areas, certain economic sectors and periods of time • Providing banking services to isolated areas

Too little lending to isolated areas, certain economic sectors and periods of time • Providing banking services to isolated areas • Lending for the development of certain economic sectors • Trickier because development impact cannot be monitored in the short-run

Too little lending to isolated areas, certain economic sectors and periods of time • Providing banking services to isolated areas • Lending for the development of certain economic sectors • Trickier because development impact cannot be monitored in the short-run • Countercyclical lending • Private banks may not internalize the expansionary effects of increasing lending during recessions

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 both industrial and developing countries, public banks have high overhead costs

The development impact of state-owned banks • OLS regressions yield a negative and statistically significant impact of state ownership of banks on subsequent financial development and GDP growth (La Porta et al., 2002) • One puzzling result is that state-owned banks seem to have a strong negative impact on growth in countries with low levels of financial development • Countries with high financial development know how to deal with the distortions brought about by PSB • The model is misspecified: • Omitted variables • The big issue is Endogeneity

Allocation of Credit • PSB reduce the effect of financial development on growth • PSB do no allocate more credit to small firms • Their lending is less procyclical than that of private banks

Summing up • On the one hand • The evidence that state ownership of banks tends to stunt financial sector development, thereby contributing to slower growthis less strong than previously thought • On the other hand • PSB have fiscal costs (especially in developing countries) • PSB play no beneficial role in terms of growth and allocative efficiency

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 • From the policy point of view • Assume PSB are bad but popular with politicians • Should policy advisors spend their limited political capital on this issue? • A clear definition of the objective function and measurement of the subsidy would allow conducting true cost-benefit analyses and address the Sisyphus Syndrome (De La Torre, 2002)

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) Public Banks in Latin America: Myths and Realities Inter-American Development Bank Research Department

Should the Government be in the Banking Business? The Role of State-Owned and Development Banks