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Session 1: The Nature and Scope of State Banking

James A. Hanson

6th Annual Financial Markets and Development Conference

The Role of State-Owned Financial Institutions: Policy and Practice

April 26-27, 2004 Washington, DC For more information, see:


Public Sector Banks and their Transformation

James A. Hanson a Senior Financial Policy Advisor Financial Operations and Policy Department, the World Bank

The opinions in this 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. The author is grateful to Jerry Caprio, Ruth Neyens, and Michael Pomerleano for comments. This paper reflects the presentations at a World Bank conference Transforming Public Sector Banks, April 9-10, 2003, Washington D.C. The presentations and some related papers are available .

14/10/2004 06:27:00

Public Sector Banks and their Transformation

A. Introduction
Public sector banks performance is important. Public banks still dominate the banking systems serving the majority of people in developing countries, despite the rash of privatizations of the last 10 years. In 2002, public sector banks represented 60 percent or more of the banking systems assets in Algeria, Bangladesh, China, Egypt, Ethiopia, India, Iran, and Vietnam.1 In Indonesia, public banks, including those under control of the Indonesian Bank Restructuring Agency, held over 60 percent of the banking systems assets, up from about 45 percent before the East Asian crisis. In Brazil, despite closure, conversion into agencies or privatization of most provincial banks, including the massive State Bank of Sao Paulo in 2001, federal banks, including the federal development bank (BNDES), held about 1/3 of bank assets and dominate lending for agriculture, housing and longer term projects. In Argentina, most of the provincial banks were privatized after 1995, but the public sector Bank of the Nation, the Bank of the Province of Buenos Aires, and the other remaining provincial banks still controlled over 30 percent of bank assets. In the transition countries, the entry of private banks and the privatization or closure of former state banks has reduced the role of public banks sharply since 1992, particularly in the Baltics and Central Europe, but public sector banks remains important in Russia and the Commonwealth Independent States (Sherif, Borish, and Gross (2003). Figure 1 indicates the importance of public sector banks in recent years.2 Since 2002, major privatizations include the remaining re-nationalized banks in Mexico, 5 banks taken over after the crisis in Indonesia, and the two of the three remaining state banks in Pakistan. Improving public sector banks performance involves first understanding the rationale for public sector banks (discussed in Section B), and how the hopes for public sector banks performance compare with the actual outcomes (Section C). To improve performance requires a further analysis of the interaction between the owners (government), the public sector bankers, and the clients (Section D). Numerous attempts have been made to improve public sector banks without much success but there are some lessons to be learned that would tend to improve their performance by making their incentives and governance more like private banks (Section E). Privatizing a public sector bank is an obvious transformation but a number of issues need attention to make privatization successful, particularly in unfavorable institutional environments (Section F). Some other options also exist for transforming public sector banks when neither reform nor privatization seems feasibleclosure, or turning the bank into an agency or a narrow bank (Section G). A brief summary is found in Section H.

Two data bases exist on the importance of public sector banks. La Porta, Lopez de Silanes and Schliefer, 2000 and 2002, refer to the share of government ownership (direct and indirect) in the 10 largest commercial and development banks in 92 countries in 1970, 1985, and 1995. Data in Barth, Caprio, and Levine, 2001a, 2001b,, updated in 2004, refer to the share of government ownership in all commercial banks in 150 countries in 2002, as reported by the countrys central bank. The La Porta, Lopez de Silanes and Schliefer data set tends to show a higher percentage of public sector ownership, as might be expected. 2 Figure 1 is based on Barth, et al, 2004, Sherif, Borish, and Gros, 2003 and World Bank estimates.

B. The Rationales for Public Sector Banks

Various overlapping political and economic rationales have been advanced for public sector banks. Politically, public sector banks may be a response to the substantial economic and political power of large private banks. Although private banks are government chartered and regulated, officials may nonetheless consider private banks to be abusing their power. As the U.S. president Andrew Jackson said in the speech accompanying his 1832 veto of the rechartering of the (private) Second Bank of the U. S., It is to be regretted that the rich and powerful too often bend the acts of government to their selfish purposes.3 More recently, as part of de-colonization, many newlyindependent African nations nationalized banks domiciled in the former colonial power. One of the many reasons for Indias 1969 bank nationalization to reduce the power of economic conglomerates and concentrated lending. In justifying Mexicos 1982 bank nationalization, president Lopez-Portillo blamed the banks (and the dollar exporters) for the pesos devaluation. Thus, to counter the economic and political power of private banks, the government may create public sector banks or nationalize private banks, rather than attempt to create competition among private banks. Of course, in small countries it is difficult to create such competition, even by the threat of entry. Second, the state-led approach to economic development that was prevalent for many years naturally involved government control of such important, potential policy instruments as banks. Lenin, just before the October 17 Revolution said, Without big banks, socialism would be impossible. The big banks are the state apparatus which we need to bring about socialism and which we take ready made from capitalism. (quoted in La Porta, Lopez de Silanes, and Shleifer, 2002, p. 266). Communist regimes in Eastern Europe, China, and Cuba, nationalized banks after World War II.4 A more moderate, post-World War II version of this rationale was that government ownership of firms in strategic sectors or commanding heights was critical to development and these firms needed assured, low-cost funding by government banks. Thus, countries that adopted socialist or planned economic regimes nationalized private banks and/or set-up public sector banks. 5 For example, Indias 1969 nationalization of 14 major banks was mainly justified by the need to control the commanding heights of the economy and to meet progressively the needs of development of the economy in conformity with national policy objectives (Preamble of the Banking Companies [Acquisition and Transfer of Undertakings] Act of 1969). The continued large role of public sector banks in many countries probably represents an overhang of these models of development.6

Remini, 1967, p. 83. The Second Bank of the United States bank was a private bank that had a monopoly on carrying out government financial activities. Remini, 1967, discusses the political issues. 4 La Porta, Lopez de Silanes, and Shleifer (2002) find a statistical tendency for more public sector control of banking in Communist and ex-Communist countries. 5 Gerschenkron (1962) was among the first to provide academic support for the view that public sector banks were needed to provide funds for large scale industrialization and long-term credit. 6 See Sherif, Borish, and Gros (2003) for a discussion of how the Transition countries in Eastern Europe and the Commonwealth of Independent States dealt with banks after 1991.

6 A third, oft-cited and related economic rationale for public sector banks has been the allocation of credits to underserved groups, not only long-term industrial credit but credit for agriculture, small businesses, housing and export finance. This rationale was not necessarily part of the state-directed approach to development, but a response to perceptions of failures in financial markets and political demands. The policy involved both redirection of nationalized banks and creation of new banks. In many countries, separate public sector development banks were set up to intermediate between foreign lenders and users of long-term credit (often public sector enterprises) or SME borrowers.7 Housing banks often were also set up. For example, in India, yet another rationale for nationalization of commercial banks was the lack of bank credit for agriculture and the importance of rural money lenders, which had been highlighted in Reserve Bank of India studies. In addition, financing agriculture was an important need signaled in Indias Fourth Plan (1969), particularly with the newly begun Green Revolution increasing credit demand to finance commercial inputs. Small businessmen were also considered neglected by Indias formal credit system. Farmers and small businessmen were thought to be able to use credit more productively than the traditional clients. Finally, deposit mobilization became a major goal to finance development, and public sector banks were urged to expand their branches.8 These issues became even more important with the 1971 Abolish Poverty campaign of then-Prime Minister Indira Gandhi.9 Of course, India had long had development banks for long term credits and created other second tier public sector institutions to provide banks with credit for agriculture and small scale industry. In Africa, concerns about foreign banks that focused on traditional export lending and neglected new industries and non-export agriculture were one of the rationales for bank nationalizations. In Latin America, concerns about long-term credits and agricultural credits led to the set-up of development banks and agricultural banks. In the Transitioncountries, sectoral banks were often set up after 1992 out of the previous mono-bank structure (Sherif, Borish, and Gross, 2003).

The World Bank made 350 loans to more than 140 development banks from the 1950s to 1984. The development banks intermediated these and other funds by acting second-tier lenders through banks, firsttier, direct lenders, or both (e.g., BNDES in Brazil). The World Banks lending initially focused on private development banks, but lending through public sector development banks came to dominate the program. 8 In India between 1969 and 1979 bank offices of public sector commercial nearly tripled, rising from about 7,200 to 22,400; in addition, regional rural banks were created in the 1970s and they had 2400 offices by the end of the decade. The growth of public sector bank offices continued in the 1980s, albeit more slowly. By 1992, there were about 44,000 commercial offices and 14,700 regional rural bank offices. Burgess and Pande, 2003, find an association between the expansion of bank offices in the social banking era, the reduction of poverty, and the expansion of non-agricultural output. 9 Interestingly, in India, social control of the private commercial banks was tried before nationalization through a National Credit Council modeled on Frances Bank Nationalization Act of 1945. The Indian Council first met in 1968 and set credit targets that the banks met. However, the targets were only a modest reallocation of credit and the government was concerned about the banks condition and the permanence of their former management (Tandon, 1989, and Sen and Vaidya, 1997). In 1969, the 14 largest private commercial banks were nationalized; this, together with the existing public sector State Bank of India, increased the public sector banks share of deposits to 86 percent. Although pressures continued for increased credits to the underserved sectors, only in March 1979 were specific priority sector requirements set (40 percent of loans of which 18 percent was for agriculture and 10 percent for the weaker sectors). In 1980, 6 more commercial banks were nationalized, raising the public sector commercial banks share to 92 percent of bank assets. In addition, Indias public sector and quasi-public sector development banks were and are relatively large.

7 Thus, the third rationale argued that public sector banks were needed to meet some perceived market failures, to be remedied by public bank loans (rather than Treasury grants). The public sector banks were a substitute for priority sector lending by private banks, or to ensure the implementation priority sector lending and extension of branch networks. They were intended to change the allocation of credit within a market system and their funding benefited from the political and economic power of the state.10 Yet, at the same time, the lack of credit also reflected the government and public enterprises preemption of an increasing fraction of bank funds and the difficulties of mobilizing deposits and allocating them an environment of repressed interest rates and uncertain legal, political and economic conditions.11 Fourth, public sector control of banks has often arisen from government takeovers of weak banks in the aftermath of crises. For example, the nationalization of the Indian banks in 1969 may also have reflected concerns regarding the frequent bankruptcies of the private banks. Numerous banks were taken over in the 1980s (Sheng, 1996, p. 2123). During the 1990s, crises and failed privatizations led to nationalizations, or renationalizations, at least temporarily, of banks in countries as diverse as the Czech Republic, Hungary, Mexico, Uganda, and Indonesia.12

C. The Performance of Public Sector Banks

In general public sector banks have performed poorly, although a few public sector banks have reasonably well. Public sector banks played a large role in Singapore and the State Bank of Mauritius is recognized as one of the best commercial banks in that country.13 The approach of Bank Rakyat Indonesia (BRI) to small credits is recognized as one of the best in the world.14 Over 90 percent of BRIs small loans continued to be performing during the Asian crisis, although BRIs corporate lending was always weak and subject to the same massive corporate defaults as the other Indonesian banks.

Public sector banks typically are able to raise money at lower rates than private banks because of the implicit state guarantee. Public sector banks also have benefited from directed credit to them. 11 La Porta, Lopez-Silanes, and Schleifer (2002) find a correlation between public sector banks and countries that they characterize as having less investor protection, less developed financial markets and more interventionist than common law countries. As is well known, high inflation countries tend to have lower ratios of bank deposits to GDP and high inflation inherently makes long-term lending difficult. 12 Insolvent private Indonesian banks were managed by the Indonesian Bank Restructuring Agency (founded in 1998). Almost all of the banks that IBRA managed had been re-privatized by end-2003. 13 The State Bank of Mauritius is owned by a number of public sector entities, not the government directly. 14 See, for example, J. Yaron, Benjamin, and Piprek, 1997 and M. Robinson, 2001 and 2002. BRI currently has about 2.9 million small-scale loans that carry market-based interest rates covering the cost of funds and expenses. About 30 percent of loans are under Indonesian Rupiah 2 million (about US$200). BRI has an enviable record of loan recovery on small credits that it maintained during the 1997-1998 crisis. This recovery probably reflects its close supervision of loans and its incentives to staff and operational units for good loan performance, within the context of decentralized authority. BRI also has a good training program. It has some 27 million deposit accounts. However, BRIs performance on small scale lending was not always good. In the 1970s under the BIMAS program, it followed the usual approach to providing subsidized credits to support the Green Revolution. As in India, this activity helped spread the Green Revolution but the credits often went to wealthier farmers; were linked to input packages that often were unsuited to the borrowers needs; and often were not repaid. BRIs current success reflects its 1984 shift to the approach described above, made possible by the general financial liberalization in 1983. See, for example, Robinson, 2002, and Cole and Slade, 1996.

Unfortunately, the performance of most public sector banks has been weak, particularly in terms of large non-performing loans (NPLs).15 For example, in China, recent official estimates suggest NPLs of around 24 percent in the four public sector commercial banks, equivalent to over 30 percent of GDP; estimates of private analysts are much higher. In Brazil, the estimated cost of recapitalizing the state (provincial banks) included some $20 billion for the bank of Sao Paulo (Banespa) before it was privatized; in 2001. In addition, the Brazilian finance ministry has estimated that the recapitalization of the federal banks, when completed, may cost over $50 billion, mostly for the recapitalization of the Federal Mortgage Bank (Caixa Economica Federal). In Africa and Eastern Europe, a number of costly restructurings of public sector banks have occurred, often more than once for the same bank.16 The 1980s also witnessed massive NPLs in public sector banks (See Sheng, 1996, pp. 21-24). These problems are of course not limited to developing countries; the cost of cleaning up Frances Credit Lyonnaise has been estimated at more than $20 billion by the European Commission. In countries where public and private banks co-exist, public banks typically have much higher ratios of NPLs to total loans. For example, in Bangladesh recently, nonperforming loans in the public sector banks were over 40 percent of loans, about 3 times the rate in private banks.17 In India, the ratio of NPLs to loans in the public sector banks in 2000 (14 percent) was about 25 percent higher than in the old private sector banks which had a similar clientele (Hanson, 2003). In Latin America, Argentinas provincial banks reported NPL ratios in 1991 of over 50 percent, more than five times those in the largest private banks (World Bank, 2001, p. 132). In Indonesia prior to the East Asian crisis, the ratio of NPLs to credit in the public sector banks was three to four times larger than in the large local private sector banks; and about 20 percent larger than the small private banks (World Bank, 1997). Of the gross cost of the crisis in the Indonesian banking system (liquidity credits to banks and replacement of bad loans by government bonds), roughly 54 percent was due to the public banks, though they accounted for less than 45 percent of banks assets before the crisis.18 Public sector banks also seem to have a correlation with higher spreads and overhead costs, in other words banking systems with a large share of public banks tend to be less efficient. La Porta, Lopez de Silanes, and Shleifer (2002) show a statistically significant, positive relation between spreads and overhead costs and the proportion of government ownership in a banking system. Barth, Caprio, and Levine et. al., (2001a) also show a positive correlation but the degree of statistical significance is lower. Reasons for the public sector banks higher spreads may be their higher costs and higher

National figures on banks NPLs should be taken as indicators, rather than definitive figures given the significant differences in national systems of bank regulation and supervision. In crises, NPLs typically turn out to be much larger than previously reported figures. 16 For some African examples, see Box 1; for Eastern Europe, see Sherif , Borish, and Gross, 2003,. Zoli, 2001, and Tang, Zoli, and Klytchnikova, 2000. 17 These figures include special (development) banks which have by far the highest NPL ratios. 18 See Enoch, et al, 2001 for data on liquidity credits by banks and Indonesian Finance Ministry data for figures on recapitalization bonds by bank. For purposes of comparison, the liquidity credit data are converted into dollars by monthly exchange rates and the bonds are converted into dollars at the exchange rate at the date of their issue.

9 costs of provisions of their higher NPLs, as is the case in India (Hanson, 2003). Meanwhile, the non-public banks in the system may not compete business away, either because they choose to lead a profitable, non-competitive life or because their ability to compete is limited by government regulations protecting the public sector banks, for example on branching or placement of treasury deposits. Of course public sector banks performance may also be rated in terms of service to underserved clients but the rhetoric and the reality of their clientele should be distinguished. First, many public sector banks have tended to lend mainly to the public sectorthat was often a rationale for their foundingbut the converse is that they often lend less to the private sector, including SMEs. For example, in Argentina, the provincial banks largely lent to the state governments. In Ghana, the state banks main lending was to the government (Box 1). In India, the banking sector, which is dominated by public sector banks, has typically lent nearly 40 percent of deposits to the government and public sector enterprises (Hanson, 2003). Barth, Caprio, and Levine (2001b) show a strong negative statistical relationship between state-owned bank assets and private sector credit. Second, the public sector banks are associated with a concentration of credit to large borrowers. La Porta, Lopez de Silanes and Schliefer (2002) find that the larger the share of public banks initially, the greater the share of bank lending to the largest 20 firms in the future. The links between state agricultural banks and large agricultural borrowers has been documented in various studies, for example, Adams and Vogel (1986), Adams et al (1984), Gonzalez-Vega (1984), Yaron (1994, 1997). A well known example is Costa Rica in the mid 1970s. The public sector Banco Nacionals interest rate subsidy on agricultural credits was equal to about 4 percent of GDP and 20 percent of agricultural value added and about 80 percent of the credit went to 10 percent of the borrowers; the average subsidy on these loans alone would have put each recipient into the upper 10 percent of the income distribution (World Bank, 1989). The negative cross-country correlations between public sector banks and later growth are not surprising, given the generally poor micro-performance of public sector banks. As noted, Barth, Caprio, and Levine (2001b) show a strong negative statistical relationship between state-owned bank assets and private sector credit, which is a key factor in growth. La Porta, Lopez de Silanes, and Shleifer (2002) find the share of government ownership of banks in 1970 is negatively correlated with per capita GDP growth from 1965 to 1995 in a large cross-country sample, controlling for other standard determinants of growth. The negative correlation is particularly strong for low-income countries. Interestingly, this correlation between state banks and growth remains even taking into account distortions such as inflation, importance of state owned enterprises and an index of government intervention. La Porta, Lopez de Silanes, and Shleifer (2002) also find a correlation between the size of public sector banking in 1970 and slower productivity growth over the 1965-1990 period.


D. Explanations for Poor Performance

Why has public sector bank performance been poor and associated with slow development? One obvious explanation is the difference in credit allocation between public sector banks and private sector bank, which is the rationale for the existence of public sector banks. Thus, unless private banks really didnt recognize the loans with best return/risk characteristics, public sector banks would do worse than private banks. In fact, the results of credit allocation by public sector banks seems to have been worse, not bettertheir non-performing loans are generally higher and their profits lower as shown in Section C. A non-performing loan means that the use of the credit was not sufficiently productive to service the loan and presumably alternative uses of the credit would have been productive. Alternatively, the recipient of the loan might use the loan proceeds for private profit that did not raise output and choose not to repay the loan.19 This means that the other clients of the lending institution or the taxpayers provided the borrower, in effect, with a subsidy. In this case output of the borrower might grow as a result of the loan, but other investors might be negatively affected because of higher taxes and higher credit costs. Thus either the productivity of the credits of public sector banks are worse than those of private banks, or that the recipients of their credits receive a subsidy that must be covered by taxes elsewhere in the system. The lower efficiency in public sector bank loans and higher NPLs on the microlevel translate into bank crises and less growth at the macroeconomic level. Moreover, in most countries there appears to be no offsetting distributional benefit from any improvement in credit access or from credit subsidies from public sector bank lending. In the view of La Porta, Lopez de Silanes, and Schliefer (2002) [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. (pp. 290). For example, in India and Indonesia, even small credit allocations were directed by government at some points in time.20 In this view, public sector banks, like other public sector enterprises are instruments to transfer wealth to supporters and, through bribes, to politicians and bureaucrats (Schleifer, 1998). No doubt part of the public sector banks poor performance across countries reflects these issues. Yet, even the best intentioned governments, aiming, for example, to improve provision of credit to underserved sectors with public sector banks, face at least five severe problems inherent in public sector banks . These problems hinder even the best motivated efforts to improve public sector bank performance.


Measured output would not grow if credits were used for capital flight, which could yield good private returns but measured negative national returns. 20 In India during the late 1980s, parliamentarian organized loan melas (fairs) at which banks simply gave loans to farmers on their signature. In Indonesia during the 1970s and early 1980s, BRI was often directed to provide credits to farmers by the Minister of Agriculture.

11 First, public sector banks suffer from multiple objectives, which makes it difficult to set-up appropriate incentives. Private banks only face the difficult task of balancing return and risk. But public sector banks face additional objectivesserve the underserved, develop parts of the economy, provide employment, and meet the sporadic demands from the state to correct financial problems. How can the government set-up incentives for the manager to meet these diverse demands? How can the owner, the state, judge how well the manager meets these objectives? Obviously trade-offs will be necessary between the objective of prudent, profitable banking and, say, the provision of access to farmers or small and medium industry. But these tradeoffs are usually are hard to specify, especially in advance, and, as discussed below, information is weak. The typical result is that managers are not really held accountable as long as they meet the sporadic requests of government and major problems do not emerge. In this context, the public bank managers, who are typically low paid, tend to avoid risks, ignore problems, and focus on a long career in public service. Moreover, one of the objectives often becomes providing employment in the banks themselves and increasing staff welfare. Public sector banks are overstaffed compared to private banks, typically. Overstaffing is often greater at lower levelsin India the ratio of management employees (officers) to assets in public sector banks were 5 times foreign banks figures, while total employees are 7 times higher (Sarkar, 1999). While salaries are usually low for the management, at the lower levels they are often high relative to similarly qualified workers. The result is that wage costs are often fairly high as a percentage of margins. In addition, public sector banks often offer their employees low interest loans (See Hanson, 2001, for the case of India). Second, information is lacking with which the owner, the state, could judge performance and hold the management accountable. Information on all banks is obscure to outsidersthe risk and return on assets may change very quickly as may funding costs on market borrowings. All banks face difficulties in providing transparent, up-to date information, particularly in developing economies. However, the public banks problems are usually much worse. Public sector banks tend to lack good information systems, because of widespread operations, weak national communications, and the lack of information technology personnel as well as funds to hire them, let alone buy equipment. The information problem is political, not just technical. The owner, the state, often requests a public sector bank to make interventions outside the banks stated objectives, for example to benefit well-connected supporters or correct problems that have arisen. The owner often wants as little public information as possible about such interventions. Hence it has only limited incentives to demand regular, up-to-date transparent information on what a public sector bank is doing. The banks management also has little incentive to ensure good information on which it can be judged, in order to ensure it maintains a comfortable life. Thus, it is to both the governments and the banks managements advantage to limit information on what the bank is doing and how well it does it. The result, unfortunately, is a lack of good information on performance and undiscovered problems that become obvious in a general crisis.

12 The information problem and conflicts of interest limit the supervision of public sector banks. Information for supervisors, a political as well as a technical problem, is lacking. If the banks managers themselves lack information, then supervisors have even less information. Lacking information, supervisors are unable to provide a strong, separate channel for analysis of a public sector banks condition. Moreover, the government, faces a conflict of interest between its role as owner of the bankwhich may seek regulatory forbearanceand as the defender of taxpayers interest. The government, lacking funds to recapitalize the banks, may apply pressure for easy supervision or encourage regulatory forbearance, such as easing of income recognition, provisioning, and restructuring norms. Supervisors may not even supervise the public sector development banks or use a different procedure for them. Of course, supervisors in developing countries tend to have little independence from the finance ministry, which is the owner of the banks. But, even if supervisors were independent, they would lack the political power to withdraw a weak public sector banks license. The market also provides no discipline to public sector banks or demand information about them. Public sector bank deposits carry an implicit government guarantee. Thus depositors in and lenders to these banks can expect to be fully repaid, irrespective of their activities, except where faith in the governments credit has declined. Third, even if public sector banks lent to the same clients as private banks, they face a political difficulty in lending at market rates and in collecting loans and executing collateral. This is true not only when they deal with the political powerful, but when they deal with poor, underserved populations. Lending rates would have to be well above prime rates to cover risks of default on long-term loans in an unstable macroeconomic environment, or on loans to underserved clients who face high risks and about whom little is known. But, such rates are typically politically impossible, so the public sector banks set lending rates well below what the market would charge. Rates also tend to be adjusted slowly to inflation. As a result, in high inflation situations, public sector banks capital is quickly eroded. This may explain many of the problems of public sector development banks in the inflationary Latin American countries.21 In less inflationary environments, an important issue in public sector banks poor performance is nonperforming loans. Here too, public sector banks face political problems. Collection is limited either because the borrowers have strong political connections or because the government would be seen as anti-poor by enforcing loan contracts and evicting mortgagees or farmers. Fourth, public banks often face a related problema culture of non-payment. Borrowers may consider the loan a transfer by the government, not requiring payment. If a noticeable number of borrowers either decide not to pay, or cannot, then borrowers in general may decide that loan repayment is foolish, would put them at a competitive disadvantage, etc., and then a general default may arise. Execution of collateral would

Indexing was used in some Latin American countries to limit the problem of keeping interest rates in line with inflation. However, when relative prices changed sharply, indexed loan contracts, like standard loan contracts, encountered problems.

13 tend to limit the culture of non-payment, but even if public banks could collect politically they would probably find it difficult because of the weak legal framework in most countries. Finally, fifth, corruption, and capture by unintended beneficiaries, noted initially, are problems that come on top of the foregoing problems that face well-meaning governments. Bank loans at less-than-market rates are desirable, even more desirable if pressures for repayment are limited. Such loans must be allocated by something other than market forces and interest rates set by banks. Borrowers will use political pressures and bribery. At the same time, the bankers, who receive civil service salaries, may seek bribes as a way of dividing the rents on the loans; the bribe is often added into the loan.22 As a result, lines of credit for small borrowers may often go to larger firms or larger farmers, as discussed above.

E. Transforming Public Sector Banks

Public sector banks poor performance typically has led to bankruptcies followed by attempts at reform. The reform usually begins with announcements that the banks will be made as good as the best commercial banks. The typical reform package involves a) New management; b) Writing off or removal of bad loans and their replacement with government debt or equity or by government takeover of an equal amount of the banks debt;23 c) Efforts to reduce costs including reducing staff and branch offices, particularly those overseas, and, in some cases, mergers; and d) Improving information technology and risk-management methodology. These reform packages have typically been unsuccessful. First, the reforms are often too small and often leave a substantial amount of bad debts on the books, but do not provide a new approach to collect these debts. One study finds a need for multiple recapitalizations in almost 25 percent of the cases of restructuring (Klingebiel and Honohan, 2002). Box 1 discusses the repeated attempts at reform in three African countries. Moreover, the write-offs and the easy treatment that the bad debtors get may encourage further defaults. Second and more importantly, the reforms do not address the fundamental problems of state banks described above: the multiple objectives of the bank, the governments own ad hoc interventions in the bank, the lack of information on the banks performance, the lack of accountability because of the multiple objectives, the

See World Bank, 1997, Box 5.13, for an example from Indonesia. Recapitalized banks are sometimes given non-tradeable, low return assets as capital. The growth of recapitalization bonds in some countries has been massive, see Hanson, 2003. 23 The bad loans that are removed may be placed in an asset management company or a treasury agency charged with debt collection. In some cases the government may write off bank liabilities to the government, guarantee loans, or assume the non performing debt of public enterprises to the bank. Tang, Zoli, and Klychnikova, 2000, discuss the various approaches that have been used in Eastern Europe. Enoch, Garcia, and Sundarajan, 1999, provide a general discussion with country examples.

14 interventions, and the desire to obscure what the banks actually do, as well as difficulties in charging enough and collecting on loans, let alone any problems of corruption To put it another way, substantial bad loans will almost certainly recur unless changes occur in the basic character of state bank along the following lines: a) Eliminate government interference in their lending, b) Improved incentives for their management and staff to lend and collect well, and an information system that permits accountability, c) Interest rates that cover costs of lending to high-risk clients, and d) Eliminate the culture of non-payment by the borrowers through enforcement of contracts. Box 1. The Rise, Reprieve, and Fall of State Banks in Africa
Where the same strong interests that derailed earlier reforms still dominate a country's politics, outcomes from bank privatization will tend to be disappointing Most African countries opted to create at least one large state bank after independence to support indigenous industries and state ventures and to make banking services available for the broad population, including those in rural areas. In many countries, these big state banks still dominate the banking sector and, after decades of politicized management and soft budget constraints, have been difficult to restructure or privatize. The disappointing results from restructuring and the problems in privatization can be seen from three [African] countries that attempted banking reform programs during the 1990s: Ghana, Tanzania, and Uganda.

Ghana started economic reforms in the early 1980s after a politically unstable period of heavy state involvement in the economy. The state owned three commercial banks, three development banks, and the Cooperative Bank. There were also two foreign banks and a merchant bank. All the state-owned banks were restructured and recapitalized under the financial reforms that started in 1987, with bad loans removed to an AMC. Management was improved through extensive technical assistance. Both before and after restructuring, the primary function of the Ghanaian banks has been funding the deficit of central government and public enterprises (this averaged 73 percent of domestic credit in the 1990s). The very high T-Bill yields received by the banks helped offset the continued loan losses from other lending. Bank privatization has been a stop-go process, being held up, for example, by disagreement between the privatization agency and external estimates of values on the price. With the program years behind schedule, the government decided to sell some shares in two state commercial banks domestically even before finding a strategic investor. This made it difficult subsequently to reduce the price to attract a strategic investor. Eventually, in late 1996, the government dropped its requirement that the strategic buyer should be a bank, and managed to sell the Social Security Bank to a consortium of foreign investment funds. By 1998, this newly privatized bank had about 13 percent of total banking system assets. The largest bank, Ghana Commercial Bank (GCB), continued to have problems even after the restructuring of the late 1980s. With the failure of a planned sale in 1996 to a Malaysian manufacturing firm, it remains government-controlled, with just 41 percent held by Ghanaians after the initial public offering (IPO). In preparation for privatization in the mid-1990s, it was found that there were serious reconciliation problems in the accounts and shortcomings in management, and some of the loss making branches had never been closed. In 1997, the senior management of GCB had to be removed in the wake of a check fraud scandal.

15 Tanzania
Twelve banks had been nationalized in 1967 and merged into a dominant commercial bank, National Bank of Commerce (NBC), which had a virtual monopoly for 25 years. The only other financial institutions were a small [state] cooperative bankand a few specialized state banks for housing. By the mid-1980s, the NBC was insolvent, illiquid, and losing money at an alarming rate. Restructuring moved a significant portion of the NPIs out of the bank, closed some loss-making branches, and retrenched staff, but operating costs as a percentage of assets doubled and spreads became negative in 1992. The bank was recapitalized in 1992, but as the losses continued to mount, restructuring intensified with an "action plan" in 1994 that changed the board of directors, curtained lending and laid off further staff. However, the salaries of the remaining staff were doubled by the new board of directors, thus offsetting the reductions in costs. The benefits from removing bad loans to the AMC were short-lived. By 1994, 77 percent of the remaining loans were nonperforming. In 1995, another attempt to restructure failed. Finally, National Commercial Bank (NBC) was split in November 1997 into two banks and a holding company. The NBC holding company took the non-banking assets, for example, staff housing and the training center. The business bank, NBC-1997, took all lending and 45 percent of the deposits, and a service bank took the remainder of the deposits. The National Microfinance Bank was to provide basic depository services to the general population, and took the small deposits but no lending. The decision to set up a microfinance bank that would keep the rural branch network may have softened some of the political opposition to the privatization of the business bank. The separation proved difficult. Poor financial and operational controls led to the need for significant provisions on unreconciled balances, and there was a significant delay in producing financial statements after the split. NBC-1997 was sold to the South African bank, Amalgamated Banks of South Africa Group (ABSA) in late 1999 with IFC participation. The microfinance bank [could not be sold. With the support of donors, an international development agency was contracted to manage and restructure the banks (Dressen, Dyer, and Northrip, 2002). It] is now focusing on the provision of payments and savings services [and some microcredits] in its 95 branches [and doing relatively well].

By the early 1990s, the government had stakes in all nine commercial banks, and owned the largest two: Uganda Commercial Bank (UCB), with about 50 percent of the market, and the Cooperative Bank. As of late 1991, about one-third of the loans of UCB were non performing, and the negative net worth of the bank was estimated at $24 million. Timid restructuring efforts started. Loss-making branches were converted into agencies rather than being closed. The AMC that was to take bad loans was not created until 1996 and, even then, there was a significant lag in transferring bad loans. There was a performance agreement in 1994 between the Ministry of Finance and the bank's board of directors, but the strategy pursued was to try to reduce the proportion of NPLs by growing the loan portfolio. Bank supervisors did not monitor compliance. Every improvement in profitability was temporary and losses continued to mount. By mid-1996, the financial position had deteriorated so that its negative net worth tripled from earlier estimates. While the government's intention was that the restructuring would culminate in privatization, management of the UCB was actively opposed to sale. Eventually, after three years of unsuccessful attempts to restructure the bank, it was agreed that a reputable merchant bank be selected to implement the sale, giving the buyer greater freedom to define which assets and branches were to be purchased. Again, there was a lag, and the merchant bank was finally hired in February 1996 and, at its request, top management was finally changed in July 1996. Losses were mounting throughout the delay, and UCB was losing market share. Audited financial statements for 1997 showed another fall in interest income, wiping out the core profits advertised to investors six months earlier. With few expressions of interest, a sale agreement was signed in late 1997 with a Malaysian industrial and real estate company, by December, 1998, however, the deal had unraveled amid allegations of corruption. Source: World Bank, 2001, Box. 3.3.

16 Without these changes in restructured banks, business continues undisturbed in its basics and new bad loans may increase rapidly. In addition to the unchanged operations, bad loans tend to increased because a) there is often political pressure to begin lending again (because the bank crisis may be associated with the need for a stabilization program that constrains other expansionary measures) and b) a public bank can raise deposits for lending because the implicit government guarantee limits market discipline. As a result, reformed public sector banks often return to bankruptcy in a few years, as seen in the experience in Africa (Box 1) and the Transitioncountries (Sherif, Borish and Gross, 2003, Zoli, 2001., and Tang, Zoli, and Klytchinikova, 2000). The few cases where restructurings have been more successful support the importance of the changes described above. 24 Specifically: a) The government should define a simple objectiveusually privatization over a short time horizonand gives the management the power to say no to requests outside that objective. In other words, the government needs to avoid intervention, except for failure to meet the well defined objective. If privatization is the objective, but timing is left vague, then restructured banks tend to revert to their earlier status. b) The new management should be chosen for their capacity to manage. All of the successful cases drew managers from reputable international banks, either a bank itself, a twining arrangement with an international bank, or citizens who had worked in such banks, though this alone is not sufficient for good results. In some cases, the management (or twinning bank) was given an incentive for good performance, based on the results of the privatizations, for example in Poland. c) Information systems should be put in place to allow the new management to monitor developments frequently with a short time lag, and to allow the finance ministry and the central bank to evaluate the progress toward the objective. If lending is aimed at targeted groups, then the information systems should also make clear the success in reaching these beneficiaries and the full costs of doing so, including interest rate subsidies and non-performance rates. d) New lending should be constrained, especially large loans, to limit new nonperforming loans. The bad loans typically were removed from the banks, although in the case of Poland they were left in the banks to be resolved by the new management before privatization (Kwalec and Kluza, 2003), and replaced by government recapitalization bonds.25 In India, where state banks continue to dominate, bank managers were given the objective to reduce their non-performing loans after the small recapitalizations done in 1994 and 1995 (about 2 percent of GDP). Generally the banks succeeded in that goal, through a combination of more careful lending, higher provisions than other banks (out of higher margins), increasing their purchases of new government debt more than other

Some relatively successful reforms that include the points described below include Korea Seoul Bank (Kang, 2003), Poland (Kwalec and Kluza, 2003), Pakistan (Sumro, 2003, Hussein, 2003), and AgBank in Mongolia and NBC in Tanzania (Dressen, Dryer, and Northrip, 2002). In all these cases, the banks were either privatized or transformed into a more narrow savings bank that focused on deposits and payments. 25 Placing bad loans in an asset management corporation (AMC) is likely to be expensive unless the AMC has a strong incentive to collect and the legal framework is strong (See Klingebiel, 2000).

17 banks, and debt restructurings that were encouraged by regulatory changes and helped by falling interest rates (Hanson 2003). Nonetheless, the non-performing loans before provisioning remain about 10 percent of loans, remained undercapitalized for many years and the state banks continue to have relatively high margins; high costs (despite savings on wage costs brought about by the a self-financed voluntary retirement scheme in 2000/01); and profits on lending that are too low to maintain the ratio of capital to un-risk weighted assets (Hanson, 2003, Reserve Bank of India, Trend and Progress in Banking, various years). There has been no consolidation within the state banks, even among those that experienced problems and required multiple capital injections, and information technology has been a problem (Verma, 2000). Some of the private banks, including some of the 9 licensed in 1994, also have experienced problems, as Indias information and legal frameworks for lending remained weak. A new, large private bank, ICICI-created recently through the merger of ICICI bank and an old private bank and then the reverse merger of ICICI development bank into that bankmay put the public sector banks under more pressure.

F. Privatization26
If in restructuring government seeks to make state banks as good as private banks, the question is why not privatize them, rather than just restructure them. Presumably one answer is that the government wishes to retain control over the credit allocation instrument, to reward favored clients, and to keep the implicit taxes and transfers provided by the public sector banks off the government budget. This suggests that politicians considering privatization of public sector enterprise may apply a sort of costbenefit calculus, and privatization occurs when the cost of continued state ownership exceeds the benefit of the ability to reward favored clients, provide employment, etc. (World Bank, 1995). Of course, this calculus must be adjusted to take into account the political support for general privatization of state-owned enterprises in the transitioneconomies. Assessing the political calculus for privatization of banks is more complex than for state enterprises, but the analysis seems hold. The most detailed studies relate to Argentina; they find that provincially owned banks tended to become privatized when the banks easy access to the central bank was ended, gains from seigniorage declined with falling inflation, and runs developed on the banks in 1995 when the Tequila Crisis hit Argentina; across provinces, badly performing banks were more likely to be privatized while large overstaffed banks in provinces with high unemployment and large public employment were less likely to be privatized (Clarke and Cull, 1999, 2002).27 There is also some tentative support for this model in Brazil (Beck and Summerhill, 2003) and across countries (Boehmer, Nash, and Netter, 2003). In Eastern Europe, the cost of serial recapitalizations played a role (Bokros, 2003). In Mexico, the government sought a large benefit from the sale of banks, which was needed to help finance the government (Haber, and Kantor, 2003)

This section focuses on state bank privatization, it does not deal extensively with privatization of private banks that have been taken over by the government during a crisis, except for the cases of Mexico and Seoul Bank. 27 On average, employment fell by over one-third in the privatized banks (Clarke and Cull, 2002).


The shift in national ideology appears to be another factor in privatization across countries. Certainly ideology played an important role in the privatization of banks in the Transitioneconomies (Table 1). The shift to a more market-based model of development also probably contributed to the bank privatizations in Latin America. On the other hand, less commitment to a market-based system and the continued strength of the postcolonial elites appears to have limited privatizations in some African countries (Box 1).
Table 1. State Ownership of Banks in Transition Economies, 19932000
(percent of assets) 1993 1996 or 1997 State Banks State Banks Share of Banks Share of Banks 93.7 3.2 77.6 54.1 2000 State Banks Share of Banks 64.8 2.6 60.4 66.0 55.4 19.8 5.7 28.2 0 0 8.6 1.9 7.1 2.9 38.9 1.1 9.8 24.0 50.0 41.9 49.1 42.2 6.8 11.9 77.5 90.9 36.7 13.9 26.0 , 1999.

Country Albania Armenia Azerbaijan Belarus Bosnia and Herzegovina Bulgaria 82.2 Croatia 36.2 Czech Republic 20.6 16.6 Estonia 25.7 6.6 Georgia 72.7 0 Hungary 74.4 16.3 Kazakhstan 4.6 28.4 Kyrgyz Republic 77.3 5.0 Latvia 24 6.9 Lithuania 53.6 54.0 Macedonia, FYR 0.0 Moldova 0.3 Poland 86.2 69.8 Romania 80.9 Russian Federation 37.0 Slovak Republic 54.2 Slovenia 40.7 Tajikistan 5.3 Turkmenistan 64.1 Ukraine Uzbekistan 75.5 Yugoslavia 92.0 Unweighted Regional averages Central and Eastern Europe 53.0 Baltics 22.5 CIS 31.9 Note : Countries without data are excluded from regional averages. Sources : Sherif, et. al, 2003; Tang, et al, 2000; EBRD, Transition Report

Despite the shift in ideology, governments in the Transitioncountries generally tended to be privatized their banks after 1995 with a few exceptions (Table 1), a timing

19 that is later than many of the other privatizations. The relative slowness of privatization may have reflected not just the desires of the governments to retain the instrument of state banksindeed, they typically retained a large interestbut macroeconomic issues and the costliness of the initial recapitalization that would be needed in the banking system. Among the larger countries in Eastern Europe, substantial bank privatization before 1995 took place only in the Czech Republic (3 of the 4 state banks were included in the voucher program; it was much less in Hungary (1 bank was partially privatized) and in Poland (2 banks were partially privatized); and in all three cases the government retained a significant ownership share in the partially privatized banks (25-30 percent). In the Czech case, the banks were privatized through vouchers that were traded in the stock market, with the government retaining a 30 percent share. The Czech banks, dominated by government and owners of other voucher-privatized companies, made loans to increasingly over-indebted companies that eventually went into default, requiring another bank recapitalization. Finally, other factors in bank privatizations seem to have been national governance and opportunities for new markets, which increased the demand for bank ownership from well-known foreign banks. In the Transitioncountries, once the possibility of access to the European Union opened up there was a large inflow of foreign banks. For example, in Bulgaria, foreign banks rose from 1 of 40 banks in 1994 to 25 of 35 in 2000, in the Czech Republic foreign banks rose from 13 of 55 banks in 1994 to 16 of 40 banks in 2000, in Hungary, they rose from 17 of 43 banks in 1994 to 30 of 38 banks in 2000 and in Poland they rose from 11 of 82 banks in 1994 to 47 of 74 in 2000 (Sherif, Borish, and Gross, 2003). Similar proportionate increases in the number of foreign banks occurred in the Baltics. In Latin America, the rapid purchase of Mexicos banks by wellknown international bankers in the second round of privatization probably reflected the likelihood of better governance and less government intervention, as signaled by NAFTA. On the other hand, concerns about relatively weak regulatory and legal environments have limited the interest of well-known international banks in Africa and much of Southeast Asia. However, South African banks have played an increasing role in the southern part of Africa at the end of the 1990s. Privatization, if done well, appears to yield significant gains. Again, the most detailed study is of provincial banks in Argentina. Estimates suggest that the present value of the cost of continuing to recapitalize the provincial banks at the usual rate was 24 times greater than the net cost of privatizingtaking the bad debts out of the bank, recapitalizing and privatizing the bank for what was typically obtained for bank assets; the estimated median saving was equal to about one-third of provincial government expenditures (Clarke and Cull, 1999).28 Once privatized, the banks non-performing loans dropped substantially and their credit allocation resembled the other private banks more than the provincial banks that were not privatized (Clarke and Cull, 1999).


The range reflects differences in assumptions regarding the discount rate and rates of recapitalization and sale returns.

20 Privatized banks also appear to be more efficient than state banks when the bank is privatized to a strategic investor, particularly a reputable foreign investor, but privatizations through the stock market, particularly when the government retains a significant share, do not seem to generate much improvement in performance and may even require further capital injections.29 These conclusions appear to be supported by a comparison between the first rounds of privatizations in the Czech Republic (3 banks) and Poland (2 banks) and the second rounds in these countries,30 in Argentina (Clarke and Cull, 1999), in Brazil in a comparison between privatized and restructured banks (Beck and Summerhill, 2003), in Nigeria (Beck, Cull, and Jerome, 2003), and in a 9 country sample (Ochere, 2003). The partially privatized banks tended to have higher loan loss provisions and higher labor costs than comparators (Ochere, 2003). Reflecting these problems, the equity shares of the partially privatized banks have tended to do worse than the market index in a 9 country sample (Ochere, 2003) and in India. Partial privatizations may also cause problems if the intent is a later sale to a strategic investor. The initial sale may later make it difficult to adjust the sale price to a strategic investor, for example as occurred in Ghana (Box 1). The minority shareholders may even be able to block the deal legally. Privatization to a well-known, international bank acting as a strategic investor seems to yield better results than where foreign participation is limited. This difference may be a major factor accounting for the improved results in the second round of privatizations in the Czech Republic and Poland and the good results so far in some other privatizations in Eastern Europe (Bonin, Hasan, and Wachtel, 2003). The reprivatizations in Mexico also produced much better results than the initial sales that were limited to nationals (Haber, 2003, Haber and Kantor, 2003). Such banks bring modern banking and risk management techniques. They also can provide some counterbalance to the dominant political elite in small countries. Of course, even such banks may run into problems in the environments of weak governance, weak information and weak legal systems that prevail in many developing countries. However, such banks will usually resolve the problems without demands for government support, since the failure to do so would be costlier, in terms of their international reputation, than the costs of resolution.31 On the other hand, privatization to foreign investors without a reputation to protect can often lead to problemsthey are probably harder to supervise than national investors, may simply pull out if conditions become bad, and may create problems if their businesses run into trouble in their home country.

See the studies presented at the World Bank Conference on Bank Privatization, Nov. 20-21, 2003. Many of the studies measure performance in terms of the degree to which banks deviate from an econometrically estimated efficiency frontier, in addition, standard indicators of performance are explored. 30 As noted above the Czech government retained 30 percent of the shares in the first round privatizations, through vouchers, and recapitalization was needed before the banks could be resold (Bonin, Hasan, and Wachtel, 2003, and Kwalec and Kluza, 2003). In Polands first round of privatization, where the state retained 30 percent of the shares, employees were sold 20 percent on preferential terms, and the rest was divided into small and large investor lots, performance improved somewhat, but much less than in the second round (Bonin, Hasan and Wachtel, 2003) 31 For example, in the recent Uruguay banking crisis, the full owned foreign banks were excluded from central bank liquidity support.

21 Although bank privatization leads to benefits, doing it well has not been easy. Delays and resistance occurs because of pressures from beneficiaries of the current arrangementsclients, management, and staffas well as nationalistic politics. Governments and ministers may face legal or political difficulties in selling a bank for less than the substantial amount that has put into it for restructuring, for example in Ghana (Box 1) and Ecuador. The valuation problem is significant, since after restructuring much of the banks assets may be government debt. Government debt in external markets may well be selling at a large discount, and if a buyer wanted to take country risk, it could simply buy that debt, rather than invest capital in a bank with all its attendant problems of dealing with bad loans that have not been removed from the books and a politically active staff accustomed to working in a public enterprise. Above all, privatization has proved costly when the buyers proved to be unsound. The worst case is the well-known first round of privatization in Mexico in 1991 to 1992.32 Foreign buyers were excluded and the buyers paid excessively for what appeared to be a protected market and access to non-arms-length lending. The banks expanded credit rapidly, not only to the industrial financial conglomerates to which they belonged (20 percent of all large loans went to insiders, see La Porta and Lopez de Silanes, 2003), but also in mortgages. The quality of the capital in the privatized banks has also been called into question, as it has been alleged that the buyers borrowed much of the funds with which they bought the banks. The rising loans increasingly proved uncollectible; the reported ratio of non-performing loans to total loans more than doubled between 1991 and 1993, reaching nearly 20 percent of loans.33 As the crisis deepened, related lending nearly doubled; its terms were much easier and the defaults much higher than those of unrelated borrowers (La Porta and Lopez de Silanes, 2003). The Mexican government was forced to renationalized the bankrupt banks; it cleaned-up their balance sheets at an estimated cost of over $70 billion (nearly 20 percent of GDP), and re-privatized them, beginning in 1998, to international banks. Such problems have developed in other privatizations. As discussed above, the first rounds of partial privatizations in the Czech Republic, Poland and Hungary led to problems, though not as big as the first round of recapitalizations; avoiding such costs was probably a factor that contributed to the inclusion of foreign investors in the latter rounds. In Africa, privatizations have often gone to nationals or foreign investors without a reputation to protect, which have later created problems in countries such as Mozambique (Mozes, 2003). In sum, since bank privatization has large benefits, moving toward it fairly rapidly is desirable, but a poor privatization can be costly. A desirable approach would probably entail improving the informational and regulatory and supervisory environment while setting a well-defined timetable for privatization. Improvements in the informational environment would include frequent publication of data on banks, internationally audited accounts, and setting up a system to publicize the recipients of the state banks loans and
32 33

See Haber and Kantor, 2003; Haber, 2003; and La Porta and Lopez-de-Silanes, 2003. These figures follow international practice and include both the past-due interest (which was what was all that was officially reported as non-performing before 1997) and the rolled-over principal of loans with pastdue interest. See Haber and Kantor, 2003, for the data.

22 subsidies on them. Subjecting the state banks to regulation and supervision similar to private banks would provide the government with an independent source of information regarding their condition. In addition, regulatory and supervisory standards should be improved to ensure reasonable capital, income recognition and provisioning standards are maintained, exposure to individual borrowers are limited, and strong prompt corrective action is in placeissues that are very important after privatization to reduce the chance of looting. The Argentine results suggest this approach is desirableits regulatory and supervisory system on the eve of privatization was one of the best in the developing world.34 It may be desirable to hire international managers but this should not occur much before the privatization occurs, as it is difficult for the state officials to supervise the managers or to maintain incentives for a long time. Recapitalization is probably necessary before privatization. The new owners typically want a relatively clean balance sheet and do not want to sort out problems of the previous managers.35 This is particularly true if the non-performing borrowers are state enterprises, where collection may be politically difficult. Recapitalization should probably not be done substantially before the privatization, lest the government decide that privatization is not necessary (See for example, Box 1). The traditional approach to recapitalization has been to recapitalize a bank by splitting it into a good bank with deposit liabilities, performing loans, and government recapitalization bonds, and a bad bank that receives that bad loans and focuses on asset recoverythe so-called Spanish model that was used in the crisis in Spain in the early 1980s. However, in Poland some success was achieved by keeping the non-performing loans in the banks and having new bank managers, who knew their clients best, who could invoke relationships to improve debt service, and who received good incentives for their performance, reduce the NPLs before privatization (Kwalec and Kluza, 2003). The actual privatization should be done to bidders who have passed a fit and proper test, and foreign buyers should be allowed to participate. In Eastern Europe, it was relatively easy to find good buyers, once it appeared that the European Union would be expanded. However, recent attempts to sell banks in other parts of the world have found it difficult to attract well-known international banks.36 When buyers are nationals or less-well-known international banks, they may be under-capitalized and subject to various pressures. Hence, good information on and good regulation and supervision of the privatized banks is extremely important to limit new losses.

Minimum capital was 11.5 percent with risk weights based on market and credit risk, liquidity requirements were 20 percent, nine of the top ten banks were well-known foreign banks, and information on the banks was readily available (World Bank, 1998). The later problems in the banking system reflected the macroeconomic problem of an over-indebted government, the freezing of deposits, and then the judicially enforced unfreezing of deposits and the asymmetric conversion of deposits and loans when the convertibility board was abolished, problems that even the best regulated and supervised banks could not withstand. 35 It is probably desirable to limit any insurance contracts against bad loans that are discovered. While failure to provide insurance will limit the sale price, the experience with such contracts has proved costly in some cases, notably the sale of Long Term Credit Bank (now Shinsei Bank) in Japan. 36 For example, in Indonesia, the sales of five banks that were taken over during the crisis received only one bid from a well-known international bank.


G. Alternatives to Restructuring and Privatization

Three broad approaches have been used to deal with state banks when neither restructuring nor privatization seems appropriate: closure and liquidation, conversion to a government agency, or conversion of a state commercial bank to a savings bank holding only government debt as assets (a narrow bank). Closure of public banks has been used in the Transitioncountries (e.g., in Yugoslavia, Romania (Bancorex), and Ukraine (Ukraina)), some of the provincial banks in Brazil,37 in Africa (e.g., Benin) and in the case of numerous development banks around the world.38 Closure has been done when the lending culture of the bank seemed well beyond repair, and it was recognized that restructuring would simply lead to more bad loans, a degree of realism that unfortunately was missing in many cases of restructuring. The key point to remember with regard to closure is that banking is essential, a particular bank is not (Andrews and Josefsson, 2003). The bank to be closed should be thought of as a service provider and consideration given to how these servicesdeposit taking, payments, loans, can be providedan approach that unfortunately is complicated by the demands of its public sector employees. Regarding deposits and payments, closure is easiest in development banks, which often have not provided these and where the source of finance was borrowing offshore or from domestic banks through directed credit. The government could simply assume these liabilities, write-off uncollectible loans, and place the remaining debts into asset recovery institutions and the courts. For commercial or savings banks, the issue is more complex. Closure of commercial banks, savings banks, and agricultural banks means depositors must be paid off or transferred. Other banks may provide deposit and payments services to the former deposits through their existing and new branches. Concerns are often raised that rural depositors may have no good alternatives for protecting their savings and making and receiving payments and remittances from their migrant family members. However, branches of the closed bank can be sold or transferred to other intermediaries, including non-bank financial institutions or micro-finance institutions, or narrow banks as discussed below. Improvement in the payments systems can allow these institutions or post office banks to handle remittances and other payments. Another concern in closure is lending to the former borrowers, in particular, the concern that small borrowers, may find it difficult to get credit. However, these fears are often overstated. In particular, bad credit often drives out good credit. Elimination of state banks that lend but do not collect can open the way for other institutions to engage in small lending, particularly if information on borrowers and the legal framework are improved (Box 2).


None of the provincial banks in Argentina were closed, because the central government provided incentives to privatize them with its Fondo Fiduciario. Access to the Fundo meant that the provinces got loans to cover their residual obligations after they split their banks into good and bad banks. 38 The membership of the Latin American Association of Financial Institutions for Economic Development (ALIDE) declined from 171 in 1988 to 73 in 2003. The decline reflected the closure of many development banks during the 1990s, for example in Peru and Argentina.

Box 2. Without State Banks Good Credit Can Drive Out Bad Credit for Small Borrowers
A standard criticism of closing or privatizing state banks is that it reduces small borrowers access to credit. It is often argued that closure will wipe out lenders to small borrowers and large foreign owners of banks will focus on only the best clients. In fact, closure or privatization may not affect small-scale lending much, and may even increase it. The rhetoric of small borrowers being served by state banks is often untrue, unfortunately. Various studies suggest that large borrowers often get the majority of state banks loans, especially in the rural areas, even from banks supposedly dedicated to small borrowers, as noted. Attempts to subsidize small borrowing encourage diversion of credits from small borrowers to politically connected borrowers. Bad credit also drives out good credit. State banks channeling of loans at below-market rates to small borrowers and neglecting collection destroy the demand for sustainable rural and SME finance. Some evidence suggests that micro credit lenders and private and foreign banks are reasonable suppliers of credit to small borrowers when the role of state banks and subsidized credits is reduced. In Bangladesh, small scale credit is done not through the state banks, but largely through Grameen type operations. In India, foreign banks credit to SMEs has grown much faster than state banks. In Argentina, Chile, and Peru, foreign banks do at least as well as local banks in providing small credits (Clarke, et al, 2004). The role of foreign banks probably reflects their technology for managing small credits; in the U.S., the cost of doing a small-scale loan has fallen below $15. Finally, private banks specializing in small credits have expanded rapidly after the decline of state banks, for example, in Ecuador (CrediFe) and Peru (MiBanco). Thus, removal of weak state bank credit from the market will create demand for sustainable small scale lending and allow providers of it to expand. The sustainable expansion of credit access can be supported by improved information on borrowers and better creditors rights. Better information on borrowers not only cuts the costs of lending, but provides an incentive for borrowers to repay in order to maintain an intangible assettheir credit rating. Attempts to improve information on borrowers are growing in many developing countries. For example, 23 developing countries have established public credit bureaus since 1994, mostly Transitioncountries. In many countries public and private credit bureaus are being improving. The legal and judicial framework, particularly with regard to the definition and execution of collateral and bankruptcy, also is important to credit access. Again, a viable threat to execute collateral, which state banks often cannot make even in the presence of a good legal and judicial framework, provides an incentive for prompt debt service. Finally, sustainable institutions for small-scale lending need to follow a few key principles: a) Collect on loans; b) Charge enough to cover costs; c) Encourage staff to reduce costs, select borrowers well, and collect loans; d) Provide deposit services which also reduces dependence on donors, and e) Provide transparent information on accounts, clientele, and any subsidies (Yaron et al, 1997). Institutions that follow these principles will contribute to sustainable access to credit; institutions that do not will tend to attract non-target borrowers and reduce the sustained development of access to credit. Although some state institutions have managed to follow these principles, notably Bank Rakyat Indonesias Unit Desa program and Thailands Bank for Agriculture and Agricultural Cooperatives (Yaron, et al, 1997), private institutions are likely to be more successful in their application than public institutions.

25 A second approach is converting a state bank or state bank offices into an agency of the federal or state government. Such an agency can disburse funds but does not take deposits. The advantage of this system is transparency. Private deposits are not used to make what, in effect, are fiscal allocations, with the billthe contingent liability of the governmentonly coming later when loans are not paid. In the agency approach, the payments to recipients are treated as expenditures and reviewed annually, as part of the budget process. Of course the review depends upon the quality of those processes. Finally, since no deposits are taken, there is less disruption of deposit taking by private banks, and more possibility of market discipline for the other banks. The agency could, of course, make loans, not expenditures. However, an agency may have even less ability to collect it loans than a public sector bank, as Cull and Xu (2000) suggest was the case in China. A third approach is conversion of a state bank into a narrow savings bank, holding only government debt as assets, an approach that limits the main problem of public sector banksfuture non-performing loans. This approach starts with the idea that the good bank, that is left after the usual restructuring approach has a large share of public sector debt and only a limited amount of loans. For example, in Indonesia in 2000, an extreme case, the state banks had less than 20 percent of their assets in loans (net of provisions) and nearly 70 percent in recapitalization bonds, cash and reserves, and central bank securities; the largest (accounting for half of the state banks) having only 10 percent loans (net of provisions) and about 75 percent in recapitalization bonds, cash and reserves, and central bank securities. A number of banks in Transitioncountries also have relatively low loan to asset ratios (Sherif, Borish, and Gross, 2003). In effect, such banks are already nearly narrow banks; they could be converted into narrow banks by the sale or transfer of the small volume of good loans to another bank, along with an equal amount of deposits, which would leave the remaining deposits and the recapitalization bonds in a narrow bank. Narrow banks have a long intellectual history and are favored by many distinguished economists because they would provide safe payment services and deposits to the public.39 Thus the conversion of a state bank into a narrow savings bank would reduce concerns that small depositors, particularly in rural areas, would lose banking and payments servicestwo of the three functions of banks. The narrow banks would, however, not lend to private or public enterprises, the banking function in which state banks have done poorly. Narrow banks have a number of advantages in addition to satisfying the need for deposit and payments servicesthey would be less subject to bank runs, help reduce monetary fluctuations (in currency plus demand deposits), and protect the payments system, compared to standard, fractional-reserve, banks.40 The

Bossone (2001) provides a good review of the history of the idea. Narrow banking received an impetus during the great depression of the 1930s, when the well-known economists Henry Simons, Lloyd Mints, and Frank Knight (Chicago) and Irving Fisher (Yale) all argued for 100 percent reserves on demand deposits to avoid bank panics and monetary fluctuations. Milton Friedman resurrected the Chicago Plan in his Program for Monetary Stability (1959). More recently, concerns about the impact of rapid financial innovation and the costs of banking crises have led to reconsideration of narrow banking, in, for example, Bossone (2001), Tobin (1985), Mishkin (1999), Phillips (1995) and World Bank (2001).

26 narrow banks have minimal credit risk, except in the case of sovereign default,41 and other risks can be limited by limiting their assets to government debt that is short-term or has floating rates.42 Consequently, narrow banks deposits do not need guarantees or deposit insurance as they are guaranteed by the assets. Supervision of the narrow banks would be easy simply checking that the investment policy is followed and deposits equal government bond holdings. Supervision would be especially easy if the government debt market were computerized and dematerialized (with ownership by book entry), as is the international trend. Finally, it is likely that narrow banks that arise from these circumstances will have plenty of assets to buy in the future, since countries where

A deposit outflow from a narrow bank, or a run in the unlikely case that it occurred, is easily managed and less complex and costly for the government than a run in a fractional-reserve, commercial bank. A narrow bank could meet the outflow by selling government debt, assuming a liquid government debt market exists. Even if such a market didnt exist, the Central Bank/Government could buy the debt or make a loan to the bank using the collateral of the government debt, and thereby avoid the risk of loss that occurs with a lender of last resort or liquidity recycling facility. To the extent that the fall in deposits in one narrow bank is deposited in another narrow bank, the receiving bank would demand an equal amount of government debt, permitting the Central Bank/Government to unwind any intervention easily. Of course, a run on a narrow bank in favor of foreign exchange would create a problem, but less than in a fractional-reserve banking system that would generate a multiple reduction in banks assets and deposits to adjust to the lower amount of bank reserves in the system. Of course, deposit shifts between narrow banks and non-narrow banks do generate broad monetary fluctuations, because of their differential in reserve requirements. Regarding the payments system, proponents of narrow banks typically have assumed, implicitly, that payments services would be done by narrow banks and non-narrow banks would have to carry out their payments through them, in order to protect the payments system. However, the increasing use of collateralized Real Time Gross Settlements payments systems reduces the risks associated with allowing non-narrow banks to participate in the payments system. 41 Recent developments in Argentina raise the risk of government default. In such circumstances, credit risk is also likely to rise on loans to private parties, and a narrow bank would likely suffer less losses than a commercial bank. Exactly how such a government default would affect depositors remains an open question. The effective default on government bonds by inflation is a more common risk than an announced default. Issuing bonds with floating interest rates to narrow banks would reduce this risk. 42 One possible risk is interest rate/term transformation risk, reflecting the possibility that interest rates may rise. If a loan or government bond can be held to maturity and is paid at face value, then the nominal risk is eliminated. However, even in that case, risks arise while the loan or government bond is maturing, because the banks marked-to-market portfolio would be less than its deposits and higher deposit interest rates would have to be paid to limit deposit outflow. These risks can be reduced by limiting narrow banks portfolio to short-term government bonds, or floating rate government debt. Of course, commercial banks are not immune to such problems typically commercial banks do some term transformation and higher interest rates would require it to increase capital, plus create risks that debt servicing by the borrowers might worsen and that the banks owners might opt for more speculative investments in order to recoup their losses. Even if a narrow bank held long-term, fixed-interest government bonds, the term transformation risk would be less for the country than with a commercial bank. The purchase or takeover of these instruments at face value by the government/central bank would liquidate an equivalent amount of government debt (at face value). The replacement of these instruments or the switch of deposits to another narrow bank, either by depositors or as a result of government intervention in a narrow bank, would entail a higher borrowing cost for the government, but the 100 percent reserve requirement would ensure that the bank receiving the deposits demanded an equivalent amount of new, higher interest rate debt. Thus, the potential cost to government of interest risks is less for narrow banks than for commercial banks, where there could be losses on assets that are taken over. A second possible risk if fraud, a risk in any bank but one that is lessened in narrow banks by the transparency of the balance sheet and the ease of supervision. A third risk is broadening the activities of a narrow bank would create risks. Trading losses are of course one possibility but trading could be limited. Other risks are the broadening of activities to other types of

27 state banks have had crises have large volumes of recapitalization bonds that are likely to grow because of interest costs. In practice, few narrow banks exist except postal savings banks. The most wellknown example is the Japanese Postal Savings Bank. These and other postal saving banks suggest that there is demand for a narrow bank, and that non-narrow banks, which could offer better returns on deposits because of the higher rates of return on assets, will not compete away all the demand for narrow bank deposits, particularly in rural areas. Of course, postal banks and narrow banks could also benefit from information technology improvements, not only to improve handling of accounts, but also remittances. Finally, public sector savings banks have often been victims of their own successtheir success in deposit mobilization has often generated funds not only for financing central government deficits but also state and local government infrastructure projects have low rates of return and difficulties in repayment. To reduce the inflows, deposit rates could be lowered, but this has also proved difficult to do politically. Of course, these problems are a long way off in countries where there has been a major bank recapitalization and much of the banking systems assets consists of public sector debt. Failed state banks have not consciously been turned into narrow banks, because the government usually wants them to start lending again. In some recent cases they have been turned into micro-credit institutions, which seem to be doing well, so far. Two examples of this approach are Mongolias AgBank and Tanzanias National Microfinance Bank, which was the rural portion of the National Bank of Commerce (Dressen, Dryer, and Northrip, 2002) . In both cases, the governments were concerned about the political ramifications of closing a failed state bank that had attracted no buyers, yet one that provided substantial banking services to much of the population. In both cases, with the support of donors, an external agency was hired to manage the bank with a contract that protected the bank from political interference. In both cases, the rural branch network proved an asset, and improved technology allowed easier access to deposits. Loans were kept smallin the case of the National Microfinance Bank the average size was less than $400, or about 1.5 times national income. Loans grew sharply, but arrears have been minimal. In both cases, the government is searching for a private buyer. This approach represents another possible solution to the problem of maintaining access to banking services when a rural state bank fails. The issue in turning failed state banks into micro credit institutions is, of course, whether these institutions can continue to collect well, or whether they will revert to the past high levels of non-performing loans if a new wave of populism develops.

H. Summary
Public sector banks continue to dominate banking for the majority of people in developing countries, although substantial privatization has occurred in Latin America and the transition countries and to a lesser degree in Africa. Public sector banks micro
lending which is where the problems started with state banks. An interesting issue here is the offering of foreign currency depositspresumably narrow banks could do this by also holding government short-term foreign currency assets, but the question is whether these assets should be domestic government or foreign government debt.

28 economic performance has been poor. Cross country evidence suggests that countries with a large public sector bank presence have slower financial and economic development, other things being equal. Public sector banks poor performance reflects the multiple objectives facing the banks, government intervention in credit decisions and collection, lack of incentives for sound information and sound lending decisions, and the publics non-payment culture with respect to public sector banks, not to speak of corruption. Serial restructurings typically have not worked because of the failure to address these problems. In the few restructurings that have succeeded, even partially, governments have set well-defined objectives that could be monitored, for example, privatization within a short time horizon, hired managers with excellent reputations and paid them reasonably; improved the banks information framework for monitoring the objectives; and avoided any interventions or requests unrelated to the pre-set objectives. Bank privatizations have reflected the high costs of the state bank approach and the shift in ideology to a more market-based approach, again particularly in Latin America and the countries. Bank privatization proved difficult in many cases, particularly where foreign banks were excluded from the bidding for the banks and strong private domestic groups took advantage of the privatizations to gain access to banks for non-arms length loans to related companies that were not repaid. On the other hand, privatization yielded substantial benefits when done well, especially in sales to wellknown, international banks that provided better risk management and were willing to cover any problems developed. Concerns that such privatizations will reduce credit to small borrowers may be overstated, in Latin America such banks have done reasonably well in lending to small borrowers. Moreover, with the bad credit of state banks no longer driving out good credit, countries have seen access to credit increase sustainably through a variety of institutions. National governance seems important in attracting well-known international banks to bid in the sales of public sector bank. The transition countries were able to sell many of their state banks to such banks, who sought a foothold in countries that would join the European Union; the attraction of Mexicos banks were increased by NAFTA. Some Latin American and African countries have also benefited from the desire of these banks to expand. However, in many areas, concerns about state intervention and legal systems have limited purchasers interest in buying state banks, or even private banks. Preparations for privatization, or even restructurings, would benefit from strengthening of the regulatory and supervisory framework, the information framework that can support market discipline, and the general legal framework. These elements are important in limiting risks if privatizations cannot be made to well-known international banks and such banks. They will also help in increasing access to credit. Where state banks have proved costly but privatizations have proved difficult, countries have tried alternatives such as a) closing state banks that had long histories of failures, b) converting state banks into agencies of the government that disbursed funds but did not take deposits and were subject to budget discipline, and conversions into variations on narrow banks

29 that provided deposit and payments services to under-served areas but limited assets to government recapitalization bonds and micro credits. Technology improvements can help to reduce costs in the latter institutions.


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