GOVERNMENT OWNERSHIP OF BANKS AND BANKING REGULATION Florencio Lopez-de-Silanes IADB Conference, Washington, DC. February 25, 2005.

2 Motivation mThere is mounting research on privatization and what the Government does in the real sector. mBut there is little knowledge about what the Government does in the financial sector. mGovernment can participate in the financing of firms in a variety of ways: m provide subsidies directly, m encourage private banks to lend to desirable projects, or m own financial institutions. mAdvantage of owning banks: m enables G to collect savings and direct them towards its chosen projects, thus promoting G’s goals. mTwo views about Government participation in financial markets.

3 Theories of Government Participation in Financial Markets mOptimistic (“Development”) View: Focuses on the necessity of financial development for economic growth. m Privately owned commercial banks were crucial in channeling savings to industry in some industrializing countries (19th century Germany). m In other countries, economic institutions were not sufficiently developed for private banks to play the crucial development role:“ The scarcity of capital in Russia was such that no banking system could conceivably succeed in attracting sufficient funds to finance a large scale industrialization …. and no bank could have successfully engaged in long term credit policies” (Gerschenkron, 1962). m In such countries, the government could step in and through its financial institutions jump start both financial and economic development. m These ideas were widely adopted with governments nationalizing or starting new banks in Africa, Asia, Latin America.

4 Theories of Government Participation in Financial Markets (2) mSkeptical (“Political”) View: m Government control of finance politicizes resource allocation for the sake of getting votes or bribes for office holders, softens budget constraints, and lowers economic efficiency (e.g., Kornai 1979). m Sustained by considerable evidence on: m Inefficiency of government enterprises, m Political motives behind public provision of services, m Benefits of privatization. mGerschenkron has some sympathy for this view: “The government as an agens movens of industrialization discharged its role in a far less than perfectly efficient manner. Incompetence and corruption of bureaucracy were great. The amount of waste in this process was formidable.” mStill, Gerschenkron considers government financing of industrialization in Russia in 1890 a great success.

5 Different Hypotheses of Gov. ownership of Banks Development and Political Views: m GoB is more prevalent in poorer countries, countries with less developed financial markets and with less well functioning institutions. Development view: m  GoB   subsequent financial development m  GoB   subsequent economic development, factor accumulation, and especially productivity growth. Political view: m  GoB  does not  subsequent financial m  GoB  does not  subsequent economic development  may  savings and capital accumulation,  but  productivity growth.

6 Outline I.Government ownership of Banks (GoB) around the world: 1.How significant is GoB in different countries? 1.What types of countries have more GoB? 1.Does GoB promote subsequent financial development? 1.Does GoB promote subsequent economic development? II.Banking Regulation: Learning to live with Private and State Banks 1.Regulation and Supervision of Lending practices of Banks 2.Why are banks usually bankrupt?  Related Lending  Poor Creditor Rights

7 Government Ownership of Banks & Industry Gov Banking in the 1970s SOE output /GDP 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

8 Government Ownership of Banks

9 II. Which Countries have High GoB? mMost characteristics come from 1990s, or are averages of  No structural interpretations (causation), only correlations. Poorer countries (1960)   GoB  financial development (1960)   GoB  G intervention in economic life   GoB  Importance of SOEs in overall economy   GoB Government spending ≠≠≠ GoB  Efficiency of government   GoB  Security of property rights, rule of law   GoB Political and financial crises in the economy ≠≠≠ GoB

10 III. Does GoB speed up Financial Development?   GoB   subsequent financial growth. Not support for the development view.

11 IV. Does GoB speed up Economic Development?   GoB  has a negative impact (  ) on subsequent economic growth.  Does not support the development view of GoB.   GoB  has a negative impact (  ) on subsequent economic growth.  Does not support the development view of GoB.

12 V. Channels through which GoB may influence Economic Development? (2)   GoB  significantly  productivity growth  Support for political view: GoB creates resource misallocations that are detrimental to productivity growth, and ultimately growth.   GoB  significantly  productivity growth  Support for political view: GoB creates resource misallocations that are detrimental to productivity growth, and ultimately growth.

13 VI. GoB and Efficiency of Resource Allocation  GoB seems to be associated wiith misallocation of resources in the economy.

14 Some Key Aspects of Banking Regulation II.Learning to live with Private and State Banks 1.Regulation and Supervision of Privatized Banks  Evidence shows that many of the failures in Privatization come as a result of lack or “re-regulation” of the industries privatized.  SOEs’ regulation was there to shield the firm from competition so as to reduce losses and subsidies  SOE’s disclosure is opaque: no real regulator to disclose to 2.Why are banks usually bankrupt?  Related Lending:  Resulting from unsound lending practices  Poor Creditor Rights  Impossible for banks to collect on defaulting debtors

15 1. Strong Creditor Rights mAlthough over-capacity may explain a bit of the problem in financial institutions, it cannot be blamed for all the malaise in the banking sector. mA key aspect of lending is collecting: m Banks, private and public, need to have effective collecting mechanisms in place. m These mechanisms are a result of creditor rights embedded in bankruptcy and reorganization laws in the enforcement of law. mEffective creditor protection has recently been shown to be a key component of the development of financial systems around the world.

16 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

17 2. Related Lending mConflicts 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 have been a problem in state owned banks. 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 in 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. m 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. m Deposit insurance makes looting more profitable.

18 Related Lending Episodes mVenezuela: m The banking system’s collapse of resulted in estimated government losses of nearly $11 billion, equivalent to 13.5% of GDP. m 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. m“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, m“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.

19 Chile: Self-loans, early 1980s

20 Mexico after the “Tequila” Crisis ( ) Related private loans/ Private loans Non-performing private loans/ Private loans BNO BAN ORO ATL BCO PRO MEX PRB BIT SER INV CEN CON ORI BPI BCR CRE UNI CIT

21 Terms of loans: Related vs. Unrelated Loans

22 Default and Recovery Rates: Related vs. Unrelated Loans

23 Conclusions mGovernment Ownership of Banks: m Some aspects of the empirical story are consistent with the 1960s view that GoB may arise as a response to institutional underdevelopment. m However, the results shed little support for the optimistic assessment of the beneficial consequences of such ownership for subsequent development. m Ultimately, GoB politicizes the resource allocation process retarding financial and economic development, especially in poor countries. mThe Common Problems with Bank Privatization: m “Re-regulation” of formerly GoBs must be undertaken. m Banks are often bankrupt as a result of: m Lenient Related Lending Practices m Poor Creditor Rights