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The Upsides and Downsides of State-Owned Commercial Banks
State-Owned Banks versus Private Banks in South Asia: Agency Tensions, Susceptibility to Distress, and the Fiscal and Economic Costs of Distress 2
The pros and cons of state banking are vigorously debated. State-owned commercial banks (SOCBs) can be established to help create markets and fulfill social goals and support fiscal policy (by raising additional revenues for public investment), but the operation of SOCBs has downsides because of possible inefficiencies, misuse, and financial distress. The upsides and downsides of SOCBs are increasingly being scrutinized by policy makers and the global community.
This chapter contributes to the debate by examining episodes of distress at SOCBs and private banks, the drivers of distress, bank adjustments in times of distress, and the costs of bank distress to the real economy in Bangladesh, India, Pakistan, and Sri Lanka. Distinguishing banks by ownership type is important because state commercial banking is prevalent in these countries, and in South Asia overall. The analysis identifies episodes of bank distress, explores several adjustment channels through which banks cope with distress, and examines the relative intensity with which state-owned and private banks in distress use these channels. The study examines how firms’ links with SOCBs versus private banks affect their investment—focusing on small and medium enterprises (SMEs) and successful firms with high growth of sales.
South Asian economies rely on their banking system to help allocate resources for greater productivity and employment as well as financial inclusion for greater access to opportunities. These functions cannot be performed effectively when banks are distressed. Therefore, understanding the drivers of distress is important for devising and implementing effective policy remedies for SOCBs. The chapter therefore concludes with recommendations to strengthen SOCBs and the financial sector for the benefit of economies and societies overall.
By 2017, three countries stood out in the world because of the dominance of SOCBs in
Note: This chapter draws on the background research paper: Kibuuka, K., and M. Melecky. 2020. “State-Owned versus Private Banks in South Asia: Agency Tensions, Distress Factors, and Real Costs of Distress.” Background paper for Hidden Debt. World Bank. Washington, DC.
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their banking systems: Belarus, Iceland, and India. In each country, SOCBs held close to 70 percent of total banking system assets (Cull, Martinez Peria, and Verrier 2017).1 Across South Asia, SOCBs hold a very high share of total banking system assets—about 40 percent, on average. However, the use of SOCBs is not confined to developing economies. In Germany, for instance, the share also hovers above 40 percent.
On the upside, using commercial and hybrid SOCBs can reflect state efforts to address market failures and create positive externalities (Atkinson and Stiglitz 1980; Stiglitz 1993; Cull, Martinez Peria, and Verrier 2017).2 Specifically, the state could use the SOCBs to (1) promote competition, extend the reach of service delivery, and spur new markets in the financial sector (Cull, Martinez Peria, and Verrier 2017; Ferrari, Mare, and Skamnelos 2017; Mazzucato and Penna 2016); (2) help resolve coordination failures (de la Torre, Gozzi, and Schmukler 2007); and (3) play countercyclical and safehaven roles in crises after markets have failed to internalize individual contributions to systemic risk (Micco and Panizza 2006; Bertay, Demirgüç-Kunt, and Huizinga 2015; Duprey 2015). The state may use SOCBs to create positive externalities by (1) financing projects with high nonmonetary social returns that have negative net present value (that is, their internal rate of return does not cross the private sector hurdle rate for investable projects) (Levy-Yeyati, Micco, and Panizza 2007), and (2) promoting strategically important industries, jumpstarting economic development, helping create new markets and national champions, and providing a source of revenue for social investments (Gerschenkron 1962; Ferrari, Mare, and Skamnelos 2017). For a global overview of development, hybrid, and commercial state-owned banks with an explicit social mandate and at least 30 percent ownership stake by the state, see de LunaMartinez and Vicente (2012).
On the downside, using SOCBs involves risks of inefficiency and misallocation costs due to agency problems and political misuse (Cull, Martinez Peria, and Verrier 2017). The agency problem relates to the conflict of interest that bureaucrats/technocrats can have when tasked with managing government-owned banks. The conflict is between the government’s interest in maximizing social welfare and the bureaucrats’ or technocrats’ interest in extracting benefits. This conflict gives rise to red tape, operational inefficiencies, and misallocation of resources (Banerjee 1997; Hart, Shleifer, and Vishny 1997). Politicians can misuse SOCBs to pursue their own interests, such as reelection and personal profit, by pushing to finance their supporters or those willing to pay the highest bribes. This misuse induces resource misallocation and economic inefficiency (Shleifer and Vishny 1994; Shleifer 1998). Politicians are more likely to favor government bank ownership when public accountability and judicial independence are low because they can extract more benefits with fewer personal consequences, Perotti and Vorage (2010) suggest.
The upsides and downsides of using SOCBs create tensions in practice. For instance, when SOCBs allocate credit inefficiently, their countercyclical role can be uncertain (Bertay, Demirgüç-Kunt, and Huizinga 2015; Coleman and Feler 2015). To address such tensions, several studies have reviewed and proposed some good practices to improve SOCB operations (Gutierrez et al. 2011; de la Torre, Gozzi, and Schmukler 2007).3
Data suggest that, in practice, SOCBs rarely have explicitly defined roles in terms of addressing market failures or creating positive externalities—at least in Europe and Central Asia (Ferrari, Mare, and Skamnelos 2017). If SOCBs have some social mandate, it may change over time: for instance, when the underlying market failure has been overcome or when policy makers reweigh competing social priorities. Unlike government-owned development financial institutions (DFIs),
