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Government Ownership of Banks

Professor Florencio Lopez-de-SilanesInternational Institute for Corporate Governance

Yale University

"The Role of State-Owned Banks: Policy and Practice."

April 26, 2004

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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.

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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:o Foreign Bankso State bankso Banks 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

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Government Ownership of Banks & Industry G

ov B

anki

ng in

the

1970

s

soe output/gdp wb78-91.012375 .65450

1 dza

arg aut

bgd

bel

bol

bra

chl

col

cri

civ

dnk

dom

ecu egy

slv

fra

deu

grc

gtm

hnd

ind

idnita

ken

kor

mys

mex

marnga

pak

pan

pry

per

phl

prt

sen

zaf

esp

lkatza

tha

tto

tun

tur

gbrusa

ury

ven

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Government Ownership of Banks

Region Government Banking in 1970

Government Banking in 2000

African average 59.92 47.7Latin American average 62.72 39.81North American average 31.2 11.87European average 63.66 37.25Middle East average 47.09 44.2Asian average 65.08 52.08Oceania average 27.18 6.16

Sample average 58.89 42.57

Share of the assets of the top 10 banks owned or controlled by the government

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GoB and Efficiency of Resource Allocation

Ind epend ent variab les

D ep end entvariab les :

G B B P Lo g G D P p erc ap ita in 1960

P rivate c red it/G D Pin 1960

Interc ep t A d justed R 2

[N ]

P rivate c laim sno ntop 20/G D P

-0.3445 b

(0.1553)-0.0181(0.0583)

0.6189 c

(0.2938)0.6091 c

(0. 3413)0.3734

[32]

Interes t rates pread

24.3407 a

(8.3999)4.2412

(4.1960)-27.8036 c

(14.6115)-8. 8076

(22.6723)0.1716

[58]

GoB is associated wiith misallocation of resources in the economy.

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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;

o Most 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.

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Insolvency and growth 5 years after crisis

Change in average GDP growth(percent)

Non-crisis

countries

-1.3

+ 0.2Crisis OECD

countries

Crisis non-

OECD countries

-0.8

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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.

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Size of Debt Markets and Creditor Protection

Deb

t Mar

kets

/GN

P

Creditor Rights*Efficiency of Judiciary0 10 20 30 40

0 10 20 30 40

0

.5

1

1.5

0

.5

1

1.5

MEX

PHL

FRA

PERCOL

PRT

BRA

ARGGRCTUR

IRL

CAN

THA

IDN

USAAUSFIN ESP

ITACHL

ZAF

KOR

BEL

NOR

PAK

SWE

JPN

NDL DEU

AUT

DNK

NZL

IND

MYS

SGPISR

GBR

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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

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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.

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Related Lending Episodes

Venezuela: The banking system’s collapse of 92-94 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, 2001.

“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.

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Chile: Self-loans, early 1980s

0% 10% 20% 30% 40% 50%

Banco de Santiago

Banco de Chile

Banco Nacional

Banco de A. Edwards

Self-loans as a percentage of total loans

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

0%20%40%60%80%

100%120%140%160%180%200%

All banks Bankrupt banks Survivor banks

Mean

Median

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Related Loans / Private Sector Loans (mean)

0%

5%

10%

15%

20%

25%

All banks Bankrupt banks Survivor banks

Before Tequilacrisis (12/93)

Six monthsafter bankbankrupcy

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Terms of loans: Related vs. Unrelated Loans

0%2%4%6%8%

10%12%14%

Interest rate forPeso loans

Interest rate forUS$ loans

Related Unrelated

0%

50%

100%

150%

200%

% loans withcollateral

Collateral value /value of loan

Related Unrelated

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Default and Recovery Rates:Related vs. Unrelated Loans

0%

10%

20%

30%

40%

50%

60%

70%

80%

Default rates Recovery rates ofbad loans

Overall Recoveryrates

Related

Unrelated

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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.

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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.