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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, 2004Washington, DC

    For more information, see:

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    http://www.worldbank.org/wbi/banking/finsecpolicy/stateowned2004/

    Public Sector Banks and their Transformation

    James A. Hanson a

    Senior Financial Policy AdvisorFinancial Operations and Policy Department, the World Bank

    a The opinions in this paper are solely those of the author and may not reflect theopinions of the World Bank, its Executive Directors, or the countries which theyrepresent. The author is grateful to Jerry Caprio, Ruth Neyens, and Michael Pomerleanofor comments. This paper reflects the presentations at a World Bank conferenceTransforming Public Sector Banks, April 9-10, 2003, Washington D.C. Thepresentations and some related papers are availablehttp://www.worldbank.org/wbi/banking/bankingsystems/psbanks/ .

    14/10/2004 06:27:00

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    http://www.worldbank.org/wbi/banking/bankingsystems/psbanks/http://www.worldbank.org/wbi/banking/bankingsystems/psbanks/http://www.worldbank.org/wbi/banking/bankingsystems/psbanks/http://www.worldbank.org/wbi/banking/bankingsystems/psbanks/http://www.worldbank.org/wbi/banking/bankingsystems/psbanks/
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    Public Sector Banks and their Transformation

    A. Introduction

    Public sector banks performance is important. Public banks still dominate thebanking systems serving the majority of people in developing countries, despite the rashof privatizations of the last 10 years. In 2002, public sector banks represented 60 percentor 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 ofthe Indonesian Bank Restructuring Agency, held over 60 percent of the banking systemsassets, 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 massiveState 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, housingand 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 offormer state banks has reduced the role of public banks sharply since 1992, particularly inthe Baltics and Central Europe, but public sector banks remains important in Russia andthe Commonwealth Independent States (Sherif, Borish, and Gross (2003). Figure 1indicates the importance of public sector banks in recent years.2 Since 2002, majorprivatizations include the remaining re-nationalized banks in Mexico, 5 banks taken overafter 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 publicsector banks performance compare with the actual outcomes (Section C). To improveperformance requires a further analysis of the interaction between the owners(government), the public sector bankers, and the clients (Section D). Numerous attemptshave been made to improve public sector banks without much success but there are somelessons to be learned that would tend to improve their performance by making theirincentives and governance more like private banks (Section E). Privatizing a publicsector bank is an obvious transformation but a number of issues need attention to makeprivatization successful, particularly in unfavorable institutional environments (SectionF). Some other options also exist for transforming public sector banks when neitherreform 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.

    1 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 largestcommercial and development banks in 92 countries in 1970, 1985, and 1995. Data in Barth, Caprio, andLevine, 2001a, 2001b,, updated in 2004, refer to the share of government ownership in all commercialbanks in 150 countries in 2002, as reported by the countrys central bank. The La Porta, Lopez de Silanesand 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.

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    B. The Rationales for Public Sector Banks

    Various overlapping political and economic rationales have been advanced forpublic sector banks. Politically, public sector banks may be a response to the substantialeconomic and political power of large private banks. Although private banks are

    government chartered and regulated, officials may nonetheless consider private banks tobe abusing their power. As the U.S. president Andrew Jackson said in the speechaccompanying 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 totheir selfish purposes.3 More recently, as part of de-colonization, many newly-independent African nations nationalized banks domiciled in the former colonial power.One of the many reasons for Indias 1969 bank nationalization to reduce the power ofeconomic conglomerates and concentrated lending. In justifying Mexicos 1982 banknationalization, president Lopez-Portillo blamed the banks (and the dollar exporters)for the pesos devaluation. Thus, to counter the economic and political power of privatebanks, 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 itis difficult to create such competition, even by the threat of entry.

    Second, the state-led approach to economic development that was prevalent formany years naturally involved government control of such important, potential policyinstruments as banks. Lenin, just before the October 17 Revolution said, Without bigbanks, socialism would be impossible. The big banks are the state apparatus which weneed to bring about socialism and which we take ready made from capitalism. (quoted inLa Porta, Lopez de Silanes, and Shleifer, 2002, p. 266). Communist regimes in EasternEurope, China, and Cuba, nationalized banks after World War II.4

    A more moderate, post-World War II version of this rationale was thatgovernment ownership of firms in strategic sectors or commanding heights wascritical to development and these firms needed assured, low-cost funding by governmentbanks. Thus, countries that adopted socialist or planned economic regimes nationalizedprivate banks and/or set-up public sector banks.5 For example, Indias 1969nationalization of 14 major banks was mainly justified by the need to control thecommanding heights of the economy and to meet progressively the needs of developmentof the economy in conformity with national policy objectives (Preamble of the BankingCompanies [Acquisition and Transfer of Undertakings] Act of 1969). The continuedlarge role of public sector banks in many countries probably represents an overhang ofthese models of development.6

    3 Remini, 1967, p. 83. The Second Bank of the United States bank was a private bank that had a monopolyon 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 controlof banking in Communist and ex-Communist countries.5 Gerschenkron (1962) was among the first to provide academic support for the view that public sectorbanks 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 Europeand the Commonwealth of Independent States dealt with banks after 1991.

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    A third, oft-cited and related economic rationale for public sector banks has beenthe allocation of credits to underserved groups, not only long-term industrial credit butcredit for agriculture, small businesses, housing and export finance. This rationale wasnot necessarily part of the state-directed approach to development, but a response toperceptions 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 foreignlenders 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 fornationalization of commercial banks was the lack of bank credit for agriculture and theimportance of rural money lenders, which had been highlighted in Reserve Bank of Indiastudies. In addition, financing agriculture was an important need signaled in IndiasFourth Plan (1969), particularly with the newly begun Green Revolution increasing creditdemand to finance commercial inputs. Small businessmen were also consideredneglected by Indias formal credit system. Farmers and small businessmen were thoughtto 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 wereurged to expand their branches.8 These issues became even more important with the1971 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 tierpublic sector institutions to provide banks with credit for agriculture and small scaleindustry. In Africa, concerns about foreign banks that focused on traditional exportlending and neglected new industries and non-export agriculture were one of therationales for bank nationalizations. In Latin America, concerns about long-term creditsand agricultural credits led to the set-up of development banks and agricultural banks. Inthe Transitioncountries, sectoral banks were often set up after 1992 out of the previousmono-bank structure (Sherif, Borish, and Gross, 2003).

    7 The World Bank made 350 loans to more than 140 development banks from the 1950s to 1984. Thedevelopment banks intermediated these and other funds by acting second-tier lenders through banks, first-tier, direct lenders, or both (e.g., BNDES in Brazil). The World Banks lending initially focused on privatedevelopment 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 about7,200 to 22,400; in addition, regional rural banks were created in the 1970s and they had 2400 offices bythe 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 andPande, 2003, find an association between the expansion of bank offices in the social banking era, thereduction of poverty, and the expansion of non-agricultural output.9 Interestingly, in India, social control of the private commercial banks was tried before nationalizationthrough 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 amodest reallocation of credit and the government was concerned about the banks condition and thepermanence of their former management (Tandon, 1989, and Sen and Vaidya, 1997). In 1969, the 14largest private commercial banks were nationalized; this, together with the existing public sector StateBank of India, increased the public sector banks share of deposits to 86 percent. Although pressurescontinued for increased credits to the underserved sectors, only in March 1979 were specific priority sectorrequirements set (40 percent of loans of which 18 percent was for agriculture and 10 percent for theweaker sectors). In 1980, 6 more commercial banks were nationalized, raising the public sectorcommercial banks share to 92 percent of bank assets. In addition, Indias public sector and quasi-publicsector development banks were and are relatively large.

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    Thus, the third rationale argued that public sector banks were needed to meetsome perceived market failures, to be remedied by public bank loans (rather thanTreasury grants). The public sector banks were a substitute for priority sector lending byprivate banks, or to ensure the implementation priority sector lending and extension ofbranch 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 publicenterprises preemption of an increasing fraction of bank funds and the difficulties ofmobilizing deposits and allocating them an environment of repressed interest rates anduncertain legal, political and economic conditions.11

    Fourth, public sector control of banks has often arisen from government takeoversof weak banks in the aftermath of crises. For example, the nationalization of the Indianbanks in 1969 may also have reflected concerns regarding the frequent bankruptcies ofthe private banks. Numerous banks were taken over in the 1980s (Sheng, 1996, p. 21-23). During the 1990s, crises and failed privatizations led to nationalizations, or re-

    nationalizations, at least temporarily, of banks in countries as diverse as the CzechRepublic, Hungary, Mexico, Uganda, and Indonesia.12

    C. The Performance of Public Sector Banks

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

    10 Public sector banks typically are able to raise money at lower rates than private banks because of theimplicit 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 andcountries that they characterize as having less investor protection, less developed financial markets andmore interventionist than common law countries. As is well known, high inflation countries tend to havelower 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 currentlyhas about 2.9 million small-scale loans that carry market-based interest rates covering the cost of funds andexpenses. 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. Thisrecovery probably reflects its close supervision of loans and its incentives to staff and operational units forgood loan performance, within the context of decentralized authority. BRI also has a good trainingprogram. It has some 27 million deposit accounts. However, BRIs performance on small scale lendingwas not always good. In the 1970s under the BIMAS program, it followed the usual approach to providingsubsidized credits to support the Green Revolution. As in India, this activity helped spread the GreenRevolution but the credits often went to wealthier farmers; were linked to input packages that often wereunsuited to the borrowers needs; and often were not repaid. BRIs current success reflects its 1984 shift tothe approach described above, made possible by the general financial liberalization in 1983. See, forexample, Robinson, 2002, and Cole and Slade, 1996.

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    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 sectorcommercial banks, equivalent to over 30 percent of GDP; estimates of private analysts

    are much higher. In Brazil, the estimated cost of recapitalizing the state (provincialbanks) included some $20 billion for the bank of Sao Paulo (Banespa) before it wasprivatized; in 2001. In addition, the Brazilian finance ministry has estimated that therecapitalization of the federal banks, when completed, may cost over $50 billion, mostlyfor the recapitalization of the Federal Mortgage Bank (Caixa Economica Federal). InAfrica and Eastern Europe, a number of costly restructurings of public sector banks haveoccurred, often more than once for the same bank.16 The 1980s also witnessed massiveNPLs in public sector banks (See Sheng, 1996, pp. 21-24). These problems are of coursenot limited to developing countries; the cost of cleaning up Frances Credit Lyonnaisehas been estimated at more than $20 billion by the European Commission.

    In countries where public and private banks co-exist, public banks typically havemuch higher ratios of NPLs to total loans. For example, in Bangladesh recently, non-performing loans in the public sector banks were over 40 percent of loans, about 3 timesthe rate in private banks.17 In India, the ratio of NPLs to loans in the public sector banksin 2000 (14 percent) was about 25 percent higher than in the old private sector bankswhich had a similar clientele (Hanson, 2003). In Latin America, Argentinas provincialbanks reported NPL ratios in 1991 of over 50 percent, more than five times those in thelargest private banks (World Bank, 2001, p. 132). In Indonesia prior to the East Asiancrisis, the ratio of NPLs to credit in the public sector banks was three to four times largerthan in the large local private sector banks; and about 20 percent larger than the smallprivate banks (World Bank, 1997). Of the gross cost of the crisis in the Indonesianbanking system (liquidity credits to banks and replacement of bad loans by governmentbonds), roughly 54 percent was due to the public banks, though they accounted for lessthan 45 percent of banks assets before the crisis.18

    Public sector banks also seem to have a correlation with higher spreads andoverhead costs, in other words banking systems with a large share of public banks tend tobe less efficient. La Porta, Lopez de Silanes, and Shleifer (2002) show a statisticallysignificant, positive relation between spreads and overhead costs and the proportion ofgovernment 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

    15

    National figures on banks NPLs should be taken as indicators, rather than definitive figures given thesignificant differences in national systems of bank regulation and supervision. In crises, NPLs typicallyturn 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 forfigures on recapitalization bonds by bank. For purposes of comparison, the liquidity credit data areconverted into dollars by monthly exchange rates and the bonds are converted into dollars at the exchangerate at the date of their issue.

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    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, eitherbecause they choose to lead a profitable, non-competitive life or because their ability tocompete is limited by government regulations protecting the public sector banks, forexample on branching or placement of treasury deposits.

    Of course public sector banks performance may also be rated in terms of serviceto underserved clients but the rhetoric and the reality of their clientele should bedistinguished. First, many public sector banks have tended to lend mainly to the publicsectorthat was often a rationale for their foundingbut the converse is that they oftenlend less to the private sector, including SMEs. For example, in Argentina, the provincialbanks largely lent to the state governments. In Ghana, the state banks main lending wasto the government (Box 1). In India, the banking sector, which is dominated by publicsector banks, has typically lent nearly 40 percent of deposits to the government andpublic sector enterprises (Hanson, 2003). Barth, Caprio, and Levine (2001b) show astrong negative statistical relationship between state-owned bank assets and private sector

    credit.

    Second, the public sector banks are associated with a concentration of credit tolarge borrowers. La Porta, Lopez de Silanes and Schliefer (2002) find that the larger theshare of public banks initially, the greater the share of bank lending to the largest 20firms in the future. The links between state agricultural banks and large agriculturalborrowers has been documented in various studies, for example, Adams and Vogel(1986), Adams et al (1984), Gonzalez-Vega (1984), Yaron (1994, 1997). A well knownexample is Costa Rica in the mid 1970s. The public sector Banco Nacionals interest ratesubsidy on agricultural credits was equal to about 4 percent of GDP and 20 percent ofagricultural value added and about 80 percent of the credit went to 10 percent of theborrowers; the average subsidy on these loans alone would have put each recipient intothe upper 10 percent of the income distribution (World Bank, 1989).

    The negative cross-country correlations between public sector banks and latergrowth are not surprising, given the generally poor micro-performance of public sectorbanks. As noted, Barth, Caprio, and Levine (2001b) show a strong negative statisticalrelationship between state-owned bank assets and private sector credit, which is a keyfactor in growth. La Porta, Lopez de Silanes, and Shleifer (2002) find the share ofgovernment ownership of banks in 1970 is negatively correlated with per capita GDPgrowth from 1965 to 1995 in a large cross-country sample, controlling for other standarddeterminants of growth. The negative correlation is particularly strong for low-incomecountries. Interestingly, this correlation between state banks and growth remains eventaking into account distortions such as inflation, importance of state owned enterprisesand 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 andslower productivity growth over the 1965-1990 period.

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    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 betweenpublic sector banks and private sector bank, which is the rationale for the existence ofpublic sector banks. Thus, unless private banks really didnt recognize the loans withbest 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 asshown in Section C. A non-performing loan means that the use of the credit was notsufficiently productive to service the loan and presumably alternative uses of the creditwould have been productive. Alternatively, the recipient of the loan might use the loanproceeds 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 aresult of the loan, but other investors might be negatively affected because of higher taxesand higher credit costs. Thus either the productivity of the credits of public sector banksare worse than those of private banks, or that the recipients of their credits receive asubsidy that must be covered by taxes elsewhere in the system.

    The lower efficiency in public sector bank loans and higher NPLs on the micro-level translate into bank crises and less growth at the macroeconomic level. Moreover, inmost countries there appears to be no offsetting distributional benefit from anyimprovement 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 reducesefficiency. (pp. 290). For example, in India and Indonesia, even small credit allocationswere 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 thepublic sector banks poor performance across countries reflects these issues.

    Yet, even the best intentioned governments, aiming, for example, to improveprovision 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 bestmotivated efforts to improve public sector bank performance.

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

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    First, public sector banks suffer from multiple objectives, which makes it difficultto set-up appropriate incentives. Private banks only face the difficult task of balancingreturn and risk. But public sector banks face additional objectivesserve theunderserved, develop parts of the economy, provide employment, and meet the sporadicdemands 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 benecessary between the objective of prudent, profitable banking and, say, the provision ofaccess to farmers or small and medium industry. But these tradeoffs are usually are hardto specify, especially in advance, and, as discussed below, information is weak. Thetypical result is that managers are not really held accountable as long as they meet thesporadic requests of government and major problems do not emerge. In this context, thepublic 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 overstaffedcompared to private banks, typically. Overstaffing is often greater at lower levelsinIndia the ratio of management employees (officers) to assets in public sector banks were5 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 highrelative to similarly qualified workers. The result is that wage costs are often fairly highas a percentage of margins. In addition, public sector banks often offer their employeeslow interest loans (See Hanson, 2001, for the case of India).

    Second, information is lacking with which the owner, the state, could judgeperformance and hold the management accountable. Information on all banks is obscureto outsidersthe risk and return on assets may change very quickly as may funding costson market borrowings. All banks face difficulties in providing transparent, up-to dateinformation, particularly in developing economies. However, the public banks problemsare usually much worse. Public sector banks tend to lack good information systems,because of widespread operations, weak national communications, and the lack ofinformation 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 statedobjectives, for example to benefit well-connected supporters or correct problems thathave arisen. The owner often wants as little public information as possible about suchinterventions. Hence it has only limited incentives to demand regular, up-to-datetransparent information on what a public sector bank is doing. The banks managementalso has little incentive to ensure good information on which it can be judged, in order toensure it maintains a comfortable life. Thus, it is to both the governments and thebanks managements advantage to limit information on what the bank is doing and howwell it does it. The result, unfortunately, is a lack of good information on performanceand undiscovered problems that become obvious in a general crisis.

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    The information problem and conflicts of interest limit the supervision of publicsector banks. Information for supervisors, a political as well as a technical problem, islacking. If the banks managers themselves lack information, then supervisors have evenless 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 ownerof the bankwhich may seek regulatory forbearanceand as the defender of taxpayersinterest. The government, lacking funds to recapitalize the banks, may apply pressure foreasy supervision or encourage regulatory forbearance, such as easing of incomerecognition, provisioning, and restructuring norms. Supervisors may not even supervisethe public sector development banks or use a different procedure for them. Of course,supervisors in developing countries tend to have little independence from the financeministry, 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 demandinformation about them. Public sector bank deposits carry an implicit governmentguarantee. 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, theyface a political difficulty in lending at market rates and in collecting loans and executingcollateral. This is true not only when they deal with the political powerful, but when theydeal with poor, underserved populations. Lending rates would have to be well aboveprime rates to cover risks of default on long-term loans in an unstable macroeconomicenvironment, or on loans to underserved clients who face high risks and about whomlittle is known. But, such rates are typically politically impossible, so the public sectorbanks set lending rates well below what the market would charge. Rates also tend to beadjusted slowly to inflation. As a result, in high inflation situations, public sector bankscapital is quickly eroded. This may explain many of the problems of public sectordevelopment banks in the inflationary Latin American countries.21 In less inflationaryenvironments, an important issue in public sector banks poor performance is non-performing loans. Here too, public sector banks face political problems. Collection islimited either because the borrowers have strong political connections or because thegovernment would be seen as anti-poor by enforcing loan contracts and evictingmortgagees 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. Ifa noticeable number of borrowers either decide not to pay, or cannot, then borrowers ingeneral may decide that loan repayment is foolish, would put them at a competitivedisadvantage, etc., and then a general default may arise. Execution of collateral would

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

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    tend to limit the culture of non-payment, but even if public banks could collect politicallythey would probably find it difficult because of the weak legal framework in mostcountries.

    Finally, fifth, corruption, and capture by unintended beneficiaries, noted initially,

    are problems that come on top of the foregoing problems that face well-meaninggovernments. Bank loans at less-than-market rates are desirable, even more desirable ifpressures for repayment are limited. Such loans must be allocated by something otherthan market forces and interest rates set by banks. Borrowers will use political pressuresand bribery. At the same time, the bankers, who receive civil service salaries, may seekbribes as a way of dividing the rents on the loans; the bribe is often added into theloan.22 As a result, lines of credit for small borrowers may often go to larger firms orlarger farmers, as discussed above.

    E. Transforming Public Sector Banks

    Public sector banks poor performance typically has led to bankruptcies followedby attempts at reform. The reform usually begins with announcements that the bankswill 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;23c) Efforts to reduce costs including reducing staff and branch offices, particularly

    those overseas, and, in some cases, mergers; andd) 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 notprovide a new approach to collect these debts. One study finds a need for multiplerecapitalizations in almost 25 percent of the cases of restructuring (Klingebiel andHonohan, 2002). Box 1 discusses the repeated attempts at reform in three Africancountries. Moreover, the write-offs and the easy treatment that the bad debtors get mayencourage further defaults.

    Second and more importantly, the reforms do not address the fundamentalproblems of state banks described above: the multiple objectives of the bank, thegovernments own ad hoc interventions in the bank, the lack of information on the banksperformance, the lack of accountability because of the multiple objectives, the

    22 See World Bank, 1997, Box 5.13, for an example from Indonesia. Recapitalized banks are sometimesgiven non-tradeable, low return assets as capital. The growth of recapitalization bonds in some countrieshas been massive, see Hanson, 2003.23 The bad loans that are removed may be placed in an asset management company or a treasury agencycharged with debt collection. In some cases the government may write off bank liabilities to thegovernment, 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.

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    interventions, and the desire to obscure what the banks actually do, as well as difficultiesin charging enough and collecting on loans, let alone any problems of corruption

    To put it another way, substantial bad loans will almost certainly recur unlesschanges 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, andan information system that permits accountability,

    c) Interest rates that cover costs of lending to high-risk clients, andd) 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 tomake 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 andsoft budget constraints, have been difficult to restructure or privatize. The disappointing results fromrestructuring and the problems in privatization can be seen from three [African] countries that attemptedbanking reform programs during the 1990s: Ghana, Tanzania, and Uganda.

    GhanaGhana started economic reforms in the early 1980s after a politically unstable period of heavy stateinvolvement in the economy. The state owned three commercial banks, three development banks, and theCooperative 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 technicalassistance. Both before and after restructuring, the primary function of the Ghanaian banks has beenfunding the deficit of central government and public enterprises (this averaged 73 percent of domesticcredit in the 1990s). The very high T-Bill yields received by the banks helped offset the continued loanlosses from other lending.

    Bank privatization has been a stop-go process, being held up, for example, by disagreement between theprivatization agency and external estimates of values on the price. With the program years behindschedule, the government decided to sell some shares in two state commercial banks domestically evenbefore finding a strategic investor. This made it difficult subsequently to reduce the price to attract astrategic investor. Eventually, in late 1996, the government dropped its requirement that the strategic buyershould be a bank, and managed to sell the Social Security Bank to a consortium of foreign investmentfunds. 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 restructuringof the late 1980s. With the failure of a planned sale in 1996 to a Malaysian manufacturing firm, it remainsgovernment-controlled, with just 41 percent held by Ghanaians after the initial public offering (IPO). Inpreparation for privatization in the mid-1990s, it was found that there were serious reconciliation problemsin the accounts and shortcomings in management, and some of the loss making branches had never beenclosed. In 1997, the senior management of GCB had to be removed in the wake of a check fraud scandal.

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    TanzaniaTwelve banks had been nationalized in 1967 and merged into a dominant commercial bank, National Bankof Commerce (NBC), which had a virtual monopoly for 25 years. The only other financial institutions werea 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 retrenchedstaff, but operating costs as a percentage of assets doubled and spreads became negative in 1992. The bankwas recapitalized in 1992, but as the losses continued to mount, restructuring intensified with an "actionplan" in 1994 that changed the board of directors, curtained lending and laid off further staff. However, thesalaries of the remaining staff were doubled by the new board of directors, thus offsetting the reductions incosts. The benefits from removing bad loans to the AMC were short-lived. By 1994, 77 percent of theremaining loans were nonperforming.

    In 1995, another attempt to restructure failed. Finally, National Commercial Bank (NBC) was split inNovember 1997 into two banks and a holding company. The NBC holding company took the non-bankingassets, for example, staff housing and the training center. The business bank, NBC-1997, took all lendingand 45 percent of the deposits, and a service bank took the remainder of the deposits. The NationalMicrofinance Bank was to provide basic depository services to the general population, and took the smalldeposits but no lending. The decision to set up a microfinance bank that would keep the rural branchnetwork may have softened some of the political opposition to the privatization of the business bank. Theseparation proved difficult. Poor financial and operational controls led to the need for significant provisionson 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 late1999 with IFC participation. The microfinance bank [could not be sold. With the support of donors, aninternational development agency was contracted to manage and restructure the banks (Dressen, Dyer, andNorthrip, 2002). It] is now focusing on the provision of payments and savings services [and somemicrocredits] in its 95 branches [and doing relatively well].

    UgandaBy 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 oflate 1991, about one-third of the loans of UCB were non performing, and the negative net worth of thebank was estimated at $24 million.

    Timid restructuring efforts started. Loss-making branches were converted into agencies rather than beingclosed. The AMC that was to take bad loans was not created until 1996 and, even then, there was asignificant lag in transferring bad loans. There was a performance agreement in 1994 between the Ministryof Finance and the bank's board of directors, but the strategy pursued was to try to reduce the proportion ofNPLs by growing the loan portfolio. Bank supervisors did not monitor compliance. Every improvement inprofitability was temporary and losses continued to mount. By mid-1996, the financial position haddeteriorated so that its negative net worth tripled from earlier estimates.

    While the government's intention was that the restructuring would culminate in privatization, managementof 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, givingthe buyer greater freedom to define which assets and branches were to be purchased. Again, there was alag, and the merchant bank was finally hired in February 1996 and, at its request, top management wasfinally changed in July 1996. Losses were mounting throughout the delay, and UCB was losing marketshare. Audited financial statements for 1997 showed another fall in interest income, wiping out the coreprofits advertised to investors six months earlier. With few expressions of interest, a sale agreement wassigned in late 1997 with a Malaysian industrial and real estate company, by December, 1998, however, thedeal had unraveled amid allegations of corruption. Source: World Bank, 2001, Box. 3.3.

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    Without these changes in restructured banks, business continues undisturbed in itsbasics 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 lendingagain (because the bank crisis may be associated with the need for a stabilization programthat 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 theexperience 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 theimportance of the changes described above.24 Specifically:

    a) The government should define a simple objectiveusually privatization over ashort time horizonand gives the management the power to say no to requestsoutside that objective. In other words, the government needs to avoidintervention, 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 totheir 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 bankitself, a twining arrangement with an international bank, or citizens who hadworked in such banks, though this alone is not sufficient for good results. In somecases, the management (or twinning bank) was given an incentive for goodperformance, based on the results of the privatizations, for example in Poland.

    c) Information systems should be put in place to allow the new management tomonitor developments frequently with a short time lag, and to allow the financeministry and the central bank to evaluate the progress toward the objective. Iflending is aimed at targeted groups, then the information systems should alsomake clear the success in reaching these beneficiaries and the full costs of doingso, including interest rate subsidies and non-performance rates.

    d) New lending should be constrained, especially large loans, to limit new non-performing loans.

    The bad loans typically were removed from the banks, although in the case of Polandthey 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 theobjective to reduce their non-performing loans after the small recapitalizations done in1994 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 ofhigher margins), increasing their purchases of new government debt more than other

    24 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 inMongolia and NBC in Tanzania (Dressen, Dryer, and Northrip, 2002). In all these cases, the banks wereeither 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 AMChas a strong incentive to collect and the legal framework is strong (See Klingebiel, 2000).

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    banks, and debt restructurings that were encouraged by regulatory changes and helped byfalling interest rates (Hanson 2003). Nonetheless, the non-performing loans beforeprovisioning remain about 10 percent of loans, remained undercapitalized for many yearsand the state banks continue to have relatively high margins; high costs (despite savingson 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-riskweighted 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 thosethat experienced problems and required multiple capital injections, and informationtechnology has been a problem (Verma, 2000). Some of the private banks, includingsome of the 9 licensed in 1994, also have experienced problems, as Indias informationand 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 thereverse merger of ICICI development bank into that bankmay put the public sectorbanks under more pressure.

    F. Privatization

    26

    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 oneanswer is that the government wishes to retain control over the credit allocationinstrument, to reward favored clients, and to keep the implicit taxes and transfersprovided by the public sector banks off the government budget. This suggests thatpoliticians considering privatization of public sector enterprise may apply a sort of cost-benefit calculus, and privatization occurs when the cost of continued state ownershipexceeds 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 thepolitical support for general privatization of state-owned enterprises in the

    transitioneconomies.

    Assessing the political calculus for privatization of banks is more complex thanfor state enterprises, but the analysis seems hold. The most detailed studies relate toArgentina; they find that provincially owned banks tended to become privatized when thebanks easy access to the central bank was ended, gains from seigniorage declined withfalling inflation, and runs developed on the banks in 1995 when the Tequila Crisis hitArgentina; across provinces, badly performing banks were more likely to be privatizedwhile large overstaffed banks in provinces with high unemployment and large publicemployment were less likely to be privatized (Clarke and Cull, 1999, 2002).27 There isalso 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 serialrecapitalizations played a role (Bokros, 2003). In Mexico, the government sought a largebenefit from the sale of banks, which was needed to help finance the government (Haber,and Kantor, 2003)

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

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    The shift in national ideology appears to be another factor in privatization acrosscountries. Certainly ideology played an important role in the privatization of banks in theTransitioneconomies (Table 1). The shift to a more market-based model of developmentalso 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 post-colonial elites appears to have limited privatizations in some African countries (Box 1).

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

    Table 1. State Ownership of Banks in Transition Economies, 19932000

    (percent of assets)

    1993 1996 or 1997 2000

    State Banks State Banks State Banks

    Country Share of Banks Share of Banks Share of Banks

    Albania 93.7 64.8

    Armenia 3.2 2.6

    Azerbaijan 77.6 60.4

    Belarus 54.1 66.0

    Bosnia and Herzegovina 55.4

    Bulgaria 82.2 19.8

    Croatia 36.2 5.7

    Czech Republic 20.6 16.6 28.2

    Estonia 25.7 6.6 0

    Georgia 72.7 0 0

    Hungary 74.4 16.3 8.6

    Kazakhstan 4.6 28.4 1.9

    Kyrgyz Republic 77.3 5.0 7.1

    Latvia 24 6.9 2.9

    Lithuania 53.6 54.0 38.9

    Macedonia, FYR 0.0 1.1

    Moldova 0.3 9.8Poland 86.2 69.8 24.0

    Romania 80.9 50.0

    Russian Federation 37.0 41.9

    Slovak Republic 54.2 49.1

    Slovenia 40.7 42.2

    Tajikistan 5.3 6.8

    Turkmenistan 64.1

    Ukraine 11.9

    Uzbekistan 75.5 77.5

    Yugoslavia 92.0 90.9

    Unweighted Regional averages

    Central and Eastern Europe 53.0 36.7Baltics 22.5 13.9

    CIS 31.9 26.0

    Note : Countries without data are excluded from regional averages.

    Sources : Sherif, et. al, 2003; Tang, et al, 2000; EBRD, Transition Report , 1999.

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    that is later than many of the other privatizations. The relative slowness of privatizationmay have reflected not just the desires of the governments to retain the instrument ofstate banksindeed, they typically retained a large interestbut macroeconomic issuesand the costliness of the initial recapitalization that would be needed in the bankingsystem.

    Among the larger countries in Eastern Europe, substantial bank privatizationbefore 1995 took place only in the Czech Republic (3 of the 4 state banks were includedin 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 governmentretained 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 thestock market, with the government retaining a 30 percent share. The Czech banks,dominated by government and owners of other voucher-privatized companies, madeloans to increasingly over-indebted companies that eventually went into default, requiringanother bank recapitalization.

    Finally, other factors in bank privatizations seem to have been nationalgovernance and opportunities for new markets, which increased the demand for bankownership from well-known foreign banks. In the Transitioncountries, once thepossibility of access to the European Union opened up there was a large inflow of foreignbanks. For example, in Bulgaria, foreign banks rose from 1 of 40 banks in 1994 to 25 of35 in 2000, in the Czech Republic foreign banks rose from 13 of 55 banks in 1994 to 16of 40 banks in 2000, in Hungary, they rose from 17 of 43 banks in 1994 to 30 of 38 banksin 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 banksoccurred in the Baltics. In Latin America, the rapid purchase of Mexicos banks by well-known international bankers in the second round of privatization probably reflected thelikelihood of better governance and less government intervention, as signaled byNAFTA. On the other hand, concerns about relatively weak regulatory and legalenvironments have limited the interest of well-known international banks in Africa andmuch of Southeast Asia. However, South African banks have played an increasing rolein the southern part of Africa at the end of the 1990s.

    Privatization, if done well, appears to yield significant gains. Again, the mostdetailed study is of provincial banks in Argentina. Estimates suggest that the presentvalue of the cost of continuing to recapitalize the provincial banks at the usual rate was 2-4 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 governmentexpenditures (Clarke and Cull, 1999).28 Once privatized, the banks non-performingloans dropped substantially and their credit allocation resembled the other private banksmore than the provincial banks that were not privatized (Clarke and Cull, 1999).

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

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    Privatized banks also appear to be more efficient than state banks when the bankis privatized to a strategic investor, particularly a reputable foreign investor, butprivatizations through the stock market, particularly when the government retains asignificant share, do not seem to generate much improvement in performance and mayeven 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 andCull, 1999), in Brazil in a comparison between privatized and restructured banks (Beckand Summerhill, 2003), in Nigeria (Beck, Cull, and Jerome, 2003), and in a 9 countrysample (Ochere, 2003). The partially privatized banks tended to have higher loan lossprovisions and higher labor costs than comparators (Ochere, 2003). Reflecting theseproblems, the equity shares of the partially privatized banks have tended to do worse thanthe 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 astrategic 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 shareholdersmay even be able to block the deal legally.

    Privatization to a well-known, international bank acting as a strategic investorseems to yield better results than where foreign participation is limited. This differencemay be a major factor accounting for the improved results in the second round ofprivatizations in the Czech Republic and Poland and the good results so far in some otherprivatizations in Eastern Europe (Bonin, Hasan, and Wachtel, 2003). The re-privatizations in Mexico also produced much better results than the initial sales that werelimited to nationals (Haber, 2003, Haber and Kantor, 2003). Such banks bring modernbanking and risk management techniques. They also can provide some counterbalance tothe dominant political elite in small countries. Of course, even such banks may run intoproblems in the environments of weak governance, weak information and weak legalsystems that prevail in many developing countries. However, such banks will usuallyresolve the problems without demands for government support, since the failure to do sowould 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 canoften lead to problemsthey are probably harder to supervise than national investors,may simply pull out if conditions become bad, and may create problems if theirbusinesses run into trouble in their home country.

    29 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 econometricallyestimated 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, andWachtel, 2003, and Kwalec and Kluza, 2003). In Polands first round of privatization, where the stateretained 30 percent of the shares, employees were sold 20 percent on preferential terms, and the rest wasdivided into small and large investor lots, performance improved somewhat, but much less than in thesecond round (Bonin, Hasan and Wachtel, 2003)31 For example, in the recent Uruguay banking crisis, the full owned foreign banks were excluded fromcentral bank liquidity support.

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    Although bank privatization leads to benefits, doing it well has not been easy.Delays and resistance occurs because of pressures from beneficiaries of the currentarrangementsclients, management, and staffas well as nationalistic politics.Governments and ministers may face legal or political difficulties in selling a bank forless 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 afterrestructuring much of the banks assets may be government debt. Government debt inexternal markets may well be selling at a large discount, and if a buyer wanted to takecountry risk, it could simply buy that debt, rather than invest capital in a bank with all itsattendant problems of dealing with bad loans that have not been removed from the booksand 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 aprotected market and access to non-arms-length lending. The banks expanded credit

    rapidly, not only to the industrial financial conglomerates to which they belonged (20percent of all large loans went to insiders, see La Porta and Lopez de Silanes, 2003), butalso in mortgages. The quality of the capital in the privatized banks has also been calledinto question, as it has been alleged that the buyers borrowed much of the funds withwhich they bought the banks. The rising loans increasingly proved uncollectible; thereported ratio of non-performing loans to total loans more than doubled between 1991and 1993, reaching nearly 20 percent of loans.33 As the crisis deepened, related lendingnearly doubled; its terms were much easier and the defaults much higher than those ofunrelated borrowers (La Porta and Lopez de Silanes, 2003). The Mexican governmentwas forced to renationalized the bankrupt banks; it cleaned-up their balance sheets at anestimated 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, thefirst rounds of partial privatizations in the Czech Republic, Poland and Hungary led toproblems, though not as big as the first round of recapitalizations; avoiding such costswas probably a factor that contributed to the inclusion of foreign investors in the latterrounds. In Africa, privatizations have often gone to nationals or foreign investors withouta reputation to protect, which have later created problems in countries such asMozambique (Mozes, 2003).

    In sum, since bank privatization has large benefits, moving toward it fairly rapidlyis desirable, but a poor privatization can be costly. A desirable approach would probablyentail improving the informational and regulatory and supervisory environment whilesetting a well-defined timetable for privatization. Improvements in the informationalenvironment would include frequent publication of data on banks, internationally auditedaccounts, and setting up a system to publicize the recipients of the state banks loans and

    32 See Haber and Kantor, 2003; Haber, 2003; and La Porta and Lopez-de-Silanes, 2003.33 These figures follow international practice and include both the past-due interest (which was what was allthat was officially reported as non-performing before 1997) and the rolled-over principal of loans with past-due interest. See Haber and Kantor, 2003, for the data.

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    subsidies on them. Subjecting the state banks to regulation and supervision similar toprivate banks would provide the government with an independent source of informationregarding their condition. In addition, regulatory and supervisory standards should beimproved to ensure reasonable capital, income recognition and provisioning standards aremaintained, exposure to individual borrowers are limited, and strong prompt corrective

    action is in placeissues that are very important after privatization to reduce the chanceof looting. The Argentine results suggest this approach is desirableits regulatory andsupervisory system on the eve of privatization was one of the best in the developingworld.34 It may be desirable to hire international managers but this should not occurmuch before the privatization occurs, as it is difficult for the state officials to supervisethe managers or to maintain incentives for a long time.

    Recapitalization is probably necessary before privatization. The new ownerstypically want a relatively clean balance sheet and do not want to sort out problems of theprevious managers.35 This is particularly true if the non-performing borrowers are stateenterprises, where collection may be politically difficult. Recapitalization should

    probably not be done substantially before the privatization, lest the government decidethat privatization is not necessary (See for example, Box 1). The traditional approach torecapitalization has been to recapitalize a bank by splitting it into a good bank withdeposit liabilities, performing loans, and government recapitalization bonds, and a badbank that receives that bad loans and focuses on asset recoverythe so-called Spanishmodel that was used in the crisis in Spain in the early 1980s. However, in Poland somesuccess was achieved by keeping the non-performing loans in the banks and having newbank managers, who knew their clients best, who could invoke relationships to improvedebt service, and who received good incentives for their performance, reduce the NPLsbefore privatization (Kwalec and Kluza, 2003).

    The actual privatization should be done to bidders who have passed a fit andproper test, and foreign buyers should be allowed to participate. In Eastern Europe, itwas relatively easy to find good buyers, once it appeared that the European Union wouldbe expanded. However, recent attempts to sell banks in other parts of the world havefound it difficult to attract well-known international banks.36 When buyers are nationalsor less-well-known international banks, they may be under-capitalized and subject tovarious pressures. Hence, good information on and good regulation and supervision ofthe privatized banks is extremely important to limit new losses.

    34 Minimum capital was 11.5 percent with risk weights based on market and credit risk, liquidityrequirements 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 reflectedthe macroeconomic problem of an over-indebted government, the freezing of deposits, and then thejudicially enforced unfreezing of deposits and the asymmetric conversion of deposits and loans when theconvertibility board was abolished, problems that even the best regulated and supervised banks could notwithstand.35 It is probably desirable to limit any insurance contracts against bad loans that are discovered. Whilefailure to provide insurance will limit the sale price, the experience with such contracts has proved costly insome 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 onebid from a well-known international bank.

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    G. Alternatives to Restructuring and Privatization

    Three broad approaches have been used to deal with state banks when neitherrestructuring nor privatization seems appropriate: closure and liquidation, conversion toa government agency, or conversion of a state commercial bank to a savings bankholding only government debt as assets (a narrow bank).

    Closure of public banks has been used in the Transitioncountries (e.g., inYugoslavia, Romania (Bancorex), and Ukraine (Ukraina)), some of the provincial banksin Brazil,37 in Africa (e.g., Benin) and in the case of numerous development banks aroundthe world.38 Closure has been done when the lending culture of the bank seemed wellbeyond repair, and it was recognized that restructuring would simply lead to more badloans, 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, aparticular bank is not (Andrews and Josefsson, 2003). The bank to be closed should bethought of as a service provider and consideration given to how these servicesdeposit

    taking, payments, loans, can be providedan approach that unfortunately is complicatedby the demands of its public sector employees. Regarding deposits and payments,closure is easiest in development banks, which often have not provided these and wherethe source of finance was borrowing offshore or from domestic banks through directedcredit. The government could simply assume these liabilities, write-off uncollectibleloans, and place the remaining debts into asset recovery institutions and the courts. Forcommercial 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 throughtheir existing and new branches. Concerns are often raised that rural depositors may haveno good alternatives for protecting their savings and making and receiving payments and

    remittances from their migrant family members. However, branches of the closed bankcan be sold or transferred to other intermediaries, including non-bank financialinstitutions or micro-finance institutions, or narrow banks as discussed below.Improvement in the payments systems can allow these institutions or post office banks tohandle remittances and other payments.

    Another concern in closure is lending to the former borrowers, in particular, theconcern that small borrowers, may find it difficult to get credit. However, these fears areoften overstated. In particular, bad credit often drives out good credit. Elimination ofstate banks that lend but do not collect can open the way for other institutions to engagein small lending, particularly if information on borrowers and the legal framework are

    improved (Box 2).

    37 None of the provincial banks in Argentina were closed, because the central government providedincentives to privatize them with its Fondo Fiduciario. Access to the Fundo meant that the provinces gotloans 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 developmentbanks during the 1990s, for example in Peru and Argentina.

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    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. Therhetoric 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 borrowerswell, 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). Institutionsthat follow these principles will contribute to sustainable access to credit; institutions that do not will tendto attract non-target borrowers and reduce the sustained development of access to credit. Although somestate institutions have managed to follow these principles, notably Bank Rakyat Indonesias Unit Desaprogram and Thailands Bank for Agriculture and Agricultural Cooperatives (Yaron, et al, 1997), privateinstitutions are likely to be more successful in their application than public institutions.

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    A second approach is converting a state bank or state bank offices into an agencyof the federal or state government. Such an agency can disburse funds but does not takedeposits. The advantage of this system is transparency. Private deposits are not used tomake what, in effect, are fiscal allocations, with the billthe contingent liability of thegovernmentonly 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 thebudget 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 privatebanks, 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 abilityto collect it loans than a public sector bank, as Cull and Xu (2000) suggest was the casein China.

    A third approach is conversion of a state bank into a narrow savings bank, holdingonly government debt as assets, an approach that limits the main problem of public sectorbanksfuture 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 sectordebt and only a limited amount of loans. For example, in Indonesia in 2000, an extremecase, 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 banksecurities; 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, andcentral bank securities. A number of banks in Transitioncountries also have relativelylow loan to asset ratios (Sherif, Borish, and Gross, 2003). In effect, such banks arealready nearly narrow banks; they could be converted into narrow banks by the sale ortransfer of the small volume of good loans to another bank, along with an equal amountof deposits, which would leave the remaining deposits and the recapitalization bonds in anarrow bank.

    Narrow banks have a long intellectual history and are favored by manydistinguished economists because they would provide safe payment services and depositsto the public.39 Thus the conversion of a state bank into a narrow savings bank wouldreduce concerns that small depositors, particularly in rural areas, would lose banking andpayments servicestwo of the three functions of banks. The narrow banks would,however, not lend to private or public enterprises, the banking function in which statebanks have done poorly. Narrow banks have a number of advantages in addition tosatisfying the need for deposit and payments servicesthey would be less subject tobank runs, help reduce monetary fluctuations (in currency plus demand deposits),andprotect the payments system, compared to standard, fractional-reserve, banks.40 The

    39 Bossone (2001) provides a good review of the history of the idea. Narrow banking received an impetusduring 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 demanddeposits to avoid bank panics and monetary fluctuations. Milton Friedman resurrected the Chicago Planin hisProgram for Monetary Stability (1959). More recently, concerns about the impact of rapid financialinnovation 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).

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    narrow banks have minimal credit risk, except in the case of sovereign default,41 andother risks can be limited by limiting their assets to government debt that is short-term orhas floating rates.42 Consequently, narrow banks deposits do not need guarantees ordeposit insurance as they are guaranteed by the assets. Supervision of the narrow bankswould be easy simply checking that the investment policy is followed and deposits

    equal government bond holdings. Supervision would be especially easy if thegovernment debt market were computerized and dematerialized (with ownership by bookentry), as is the international trend. Finally, it is likely that narrow banks that arise fromthese circumstances will have plenty of assets to buy in the future, since countries where

    40 A deposit outflow from a narrow bank, or a run in the unlikely case that it occurred, is easily managedand less complex and costly for the government than a run in a fractional-reserve, commercial bank. Anarrow bank could meet the outflow by selling government debt, assuming a liquid government debtmarket exists. Even if such a market didnt exist, the Central Bank/Government could buy the debt ormake a loan to the bank using the collateral of the government debt, and thereby avoid the risk of loss thatoccurs with a lender of last resort or liquidity recycling facility. To the extent that the fall in deposits inone 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. Ofcourse, a run on a narrow bank in favor of foreign exchange would create a problem, but less than in afractional-reserve banking system that would generate a multiple reduction in banks assets and deposits toadjust to the lower amount of bank reserves in the system. Of course, deposit shifts between narrow banksand non-narrow banks do generate broad monetary fluctuations, because of their differential in reserverequirements. 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 tocarry out their payments through them, in order to protect the payments system. However, the increasinguse of collateralized Real Time Gross Settlements payments systems reduces the risks associated withallowing non-narrow banks to participate in the payments system.41 Recent developments in Argentina raise the risk of government default. In such circumstances, creditrisk is also likely to rise on loans to private parties, and a narrow bank would likely suffer less losses than acommercial 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 anannounced 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 ratesmay rise. If a loan or government bond can be held to maturity and is paid at face value, then the nominalrisk 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 interestrates would have to be paid to limit deposit outflow. These risks can be reduced by limiting narrow banksportfolio to short-term government bonds, or floating rate government debt. Of course, commercial banksare not immune to such problems typically commercial banks do some term transformation and higherinterest rates would require it to increase capital, plus create risks that debt servicing by the borrowersmight worsen and that the banks owners might opt for more speculative investments in order to recoup theirlosses. Even if a narrow bank held long-term, fixed-interest government bonds, the term transformationrisk 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 ofgovernment debt (at face value). The replacement of these instruments or the switch of deposits to anothernarrow bank, either by depositors or as a result of government intervention in a narrow bank, would entail ahigher borrowing cost for the government, but the 100 percent reserve requirement would ensure that thebank receiving the deposits demanded an equivalent amount of new, higher interest rate debt. Thus, thepotential cost to government of interest risks is less for narrow banks than for commercial banks, wherethere could be losses on assets that are taken over. A second possible risk if fraud, a risk in any bank butone 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 createrisks. Trading losses are of courseone possibility but trading could be limited. Other risks are the broadening of activities to other types of

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    state banks have had crises have large volumes of recapitalization bonds that are likely togrow because of interest costs.

    In practice, few narrow banks exist except postal savings banks. The most well-known 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, whichcould offer better returns on deposits because of the higher rates of return on assets, willnot 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 technologyimprovements, not only to improve handling of accounts, but also remittances. Finally,public sector savings banks have often been victims of their own successtheir successin deposit mobilization has often generated funds not only for financing centralgovernment deficits but also state and local government infrastructure projects have lowrates of return and difficulties in repayment. To reduce the inflows, deposit rates couldbe lowered, but this has also proved difficult to do politically. Of course, these problemsare 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, becausethe government usually wants them to start lending again. In some recent cases they havebeen turned into micro-credit institutions, which seem to be doing well, so far. Twoexamples of this approach are Mongolias AgBank and Tanzanias NationalMicrofinance Bank, which was the rural portion of the National Bank of Commerce(Dressen, Dryer, and Northrip, 2002


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