Successes and Failures in Bank Privatization: Lessons from Six Country Case Studies

Alfredo Dammert and Esperanza Lasagabaster (SASFP)

A wave of financial liberalization has swept across the world since the 1970s, reversing trends of high state intervention.

Liberalization has occurred in all its dimensions:

elimination of credit controls and interest rate ceilings, sale of state-owned banks, entry of new private banks …..

Despite these positive trends, public ownership of banks remains well entrenched in some countries, especially in South Asia, some regions in Africa, and the Middle East.

Wide public ownership impedes the development of efficient financial markets.

Empirical literature supports these findings, e.g., La Porta, Lopez-de-Silanes, and Shleifer

(2000) and Barth, Caprio, and Levine (2001).

Although there are real advantages to private ownership of banks, a mere change of hands has not always yielded positive results, and in some cases, it has even been followed by a crisis.

The critical policy question emerges of how to privatize banks while avoiding the risks inherent in the process.

This presentation examines factors that are bound to make bank privatization succeed or fail, drawing on different country experiences, especially, Argentina, Brazil, Latvia, Mexico, Mozambique, and Poland.

The presentation is divided in three sections: Strategies for bank privatizationThe importance of a strong regulatory framework to support lending by the newly privatized banks.The political economy of bank privatization

I. Strategies for bank privatization

State banks can be privatized in many ways—by focusing on a strategic investor; on wide ownership through IPOs, vouchers; and/or transfer to staff. The approach selected is critical:

It will affect the bank’s governance structure and opportunities for introducing new technology, modern banking skills, and fresh capital.

I. Bank privatization strategiesSummary table

Key Country Advantage Disadvantage

Method

Strategic Argentina, New corporate Politically InvestorBrazil governance controversial

Limited to Mexico Less political Constraints on:

local opposition skills transfer strategic capital

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I. Bank privatization of strategiesSummary table (continued)

Key Country Advantage DisadvantageMethod

IPO Poland More political Diffused ownership support No new skills New capital Requires supporting Potential capital capital market market growth infrastructure

Voucher Czech More political Diffused ownership Repub. support No new skills

Employee Russia Politically Diffused ownership expedient No new skills

I.a. Poland’s case Privatization process was slow, strategy changed frequently, and at times reflected inconsistent objectives. State zeal to retain influence came at odds with the search for a strategic investor that would a minority but actively participate in management. Strategy also emphasized IPOs aimed at domestic investors to gain political support and foster local capital market development.

I.a. Poland’s case. Bank SlaskiThe privatization of Bank Slaski highlighted IPO problems in a nascent capital market. Initially, the sale comprised a mix of IPO with a strategic investor. The tender was cancelled posing a problem in setting the IPO reference price.Unexpectedly, an agreement was reached with ING.

I.a. Poland’s case. Bank SlaskiThe IPO price was set at a low level, leading to a large oversubscriptionInexperienced Polish brokerage houses were unable to complete registration of shares before first day of trading. Share prices skyrocketed New investors were disgruntled and a public inquiry followed.Circumstances of Bank Slaski’s sale did not help public support for the privatization process.

I. Bank privatization strategies

A mixed privatization model has often been used to draw on the advantages of each approach. In a mixed model, the role of the strategic investor is still critical and its selection should follow a transparent and rigorous process

Open to foreign investorsGovernment due diligence of new owners

I. Privatization strategies: Should a government restructure a bank prior to its sale?

This is an important policy questionRestructuring may delay privatization, demand specialized human resources, and force to government to recognize up-front the bad portfolio. Selling a bank with a bad portfolio detracts sound investors who do not want to chase after bad debtors.

I. Privatization strategies: restructuring options prior to sale

Key methodCountry Outcome

Modest Mozambique Contributed to badrestructuring performance of sold bank

Internal Poland Privatization delaysrestructuring Weaker portfolio of

sold bank

Separate good Argentina Faster privatizationvs. bad bank Greater public effort in

tackling bad loans Up-front loss recognition

Liquidation and Nicaragua Save few good assetsselective branch sale

*Second privatization wave

II. Weak financial regulation/supervision at the heart of many failed bank privatizations

A shift from a state-dominated banking sector to a private system in a liberalized environment requires a strong supporting infrastructure to protect the stability of the new system.Most countries implementing such far-reaching reforms –Mexico, Chile, and Mozambique as well as most transition economies—neglected or relegated to a second stage matters necessary for markets to function properly…...

II. Weak financial regulation/supervision at the heart of many failed bank privatizations

A few years after privatization, many entities were experiencing financial distress (Mozambique) and this often spread into a systemic crisis (Mexico, Latvia). Ex-post, countries realized that the building blocks were missing: regulations were weak, supervision was lax.Markets were not fully developed, and regulatory and supervisory provisions were all the more important.

II.a. Mexico’s case: a hasty privatization coupled with weak regulations

The 1992 privatization process was hasty. In 15 months, 18 commercial banks were sold for US$12.5 billion.The sale was initially hailed as a great success, especially for the high prices fetched. Controlling shares were all sold to domestic groups, mostly to securities brokerage houses. Foreign participation that could have brought new skills and capital was explicitly restricted.

II.a Mexico’s case: a hasty privatization coupled with weak regulations (continued)

The government had not performed sufficient due diligence. In some cases, owners borrowed to acquire the banks—bringing debt not capital.A lending boom followed the privatization, portfolios quickly deteriorated. Lending was supported by foreign borrowing exposing banks to high exchange and interest rates risks.Regulatory changes introduced in 1990 were inadequate. Only in 1994 did supervision start to receive more attention.

II.a Mexico’s case: a hasty privatization coupled with weak regulations (continued)

The 1994 devaluation proved disastrous given exchange and interest rate risks. The government responded to the crisis with various programs that avoided depositors’ lost of trust but at high fiscal costs. Overall, crisis resolution was protracted increasing its costs.Mexico’s unfortunate experience highlights the importance of conducting privatization in a sound regulatory and supervisory environment.

III. Political economy of bank privatization

Building political momentum for privatization is challenging.At times, privatization only came about after state banks suffered mounting losses.In other cases, an economic crisis and the resolve to renew economic growth marked the turning point.

III. Political economy of bank privatization

Privatization of provincial and state banks in Argentina and Brazil was an arduous task. The great divide between benefits drawn by local governments and the costs imposed on the nation at large exacerbated the governance problem, perpetuating a vicious circle of bad financial performance by state banks followed by central bank or federal support. Privatization was only possible after recapitalization costs of distressed banks were transferred to the owners—provinces and states.

III. Political economy of bank privatization: relaxing constraints. Political obstacles often explain privatization strategies, e.g., including a small share of IPOs to allow wider ownership. Labor’s acceptance of privatization is central. To ease labor constraints, governments have

compensated laid off workers, established limits on the number of workers that can be laid off,transferred or sold a percentage of shares to workers, at a discount (Poland), and in Russia, a more massive transfer of assets took place but with a poor outcome.

III. Political economy of bank privatization: relaxing constraints. The sale of provincial and state banks in Argentina and Brazil involved a special dimension.Federal governments played a key role in easing the financial costs of privatization for the states and provinces.In Argentina, for example, provinces led the sales and assumed short-term costs related to bank clean up, but the federal government created a fund to on-lend to the provinces and transform these short-term costs into long-term debt.

Summing up…... Privatization can lead to greater efficiency but ownership transfer does not always guarantee good performance.Regulatory and supervisory weaknesses have been at the root of many privatization failures (e.g., Mexico, Mozambique, and Latvia).Successful privatization requires a well-developed and coherent strategy. Strategic investors can play a key role in improving the bank’s governance but a stringent pre-qualification process is necessary.

Summing up…...

Foreign investors can bring fresh capital and skills, especially important in financial systems that were previously dominated by state participation where local players enjoy little banking experience. The separation of the good from the bad bank is paramount.