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The AAF Virtual Debates: Charles Calomiris's Response on State-Owned Banks

Charles Calomiris's picture

I have to admit, I am a bit puzzled by my friend Franklin Allen’s first entry in this debate. There simply is no evidence—none—in support of his statement that mixed systems of state and private banking tend to be a good idea. And his mention of China is doubly puzzling. China’s state-owned banks have been a disaster, fiscally, allocatively, and socially. They cost the Chinese people hundreds of billions of dollars in bailout costs a decade ago, and, according to most informed observers, may very well soon repeat a similar magnitude of losses. Allocatively, they are famously wasteful of resources, as they have been a political tool for propping up the unproductive state-owned sector, which explains their continuing huge losses (recognized and unrecognized). The internal corporate governance of these unwieldy institutions is a nightmare. The financing arrangements that have succeeded in attracting private capital are well understood to be a political deal between global banks and the Chinese government; global banks invest in the state-owned sector as part of the price they must pay for entry into the Chinese market. And these banks are the central nexus of corruption and influence peddling in Chinese society. China’s growth has occurred in spite of these banks’ distorted lending policies, not because of them.

Some observers have wondered how it was possible for China to grow despite the lack of a deep private formal lending sector. The answer is simple: If a country’s basic economic development is constrained for centuries, then when economic liberalization finally occurs, the marginal product of capital is huge and high returns can be generated from almost any reasonably well-managed enterprise. If retained earnings can reliably earn high annual returns irrespective of how they are invested, growth will be rapid even without a banking system. But that initial bank-independent growth is not sustainable. The Chinese government’s recent financial policy initiatives show that it is well aware that China’s continuing growth is highly dependent on its ability to develop the legal, political, and institutional foundations that will support increasingly selective, private, arms-length lending for productive investments. That transformation of the Chinese banking system is a future prospect, not a current reality, and it is by no means a certainty (see, for example, Minxin Pei’s book, China’s Trapped Transition, or the contributions to my edited volume, China’s Financial Transition at the Crossroads).

Almost two decades ago Charles Himmelberg and I studied the record of industrial directed credit in Japan. Although our study found evidence for success on the part of the Japan Development Bank (JDB) in assisting the growth of Japan’s machine tool industry in the 1960s and 1970s, I came away from that study even more sceptical of state-owned banks than when we had begun, and I advised countries that were contemplating the imitation of Japan that it would be virtually impossible to export the Japanese success to other countries (as the dismal record of state-owned banks then and since has shown).

Japanese industrial directed credit was an exception, both internationally, and even within Japan. No other country of which I am aware was able to match the JDB’s record of success. And other government lending programs in Japan—especially in support of infrastructure projects—were well known as a hotbed of waste and corruption. The JDB’s brief success in the narrow sphere of industrial credit reflected the uniquely Japanese political economy of lending allocation, based on a unique institutional structure comprised of (1) Deliberative councils, which expressed competing industrial demands; and (2) A credibly independent authority, namely the JDB, which jealously guarded its independence over the allocation of funding. That independence translated into lending programs that were capable of selecting viable young firms for loans based on economic criteria, and did not support them repeatedly. In my experience, these factors are not simply rare; they are unique.

At the World Bank there is a new openness to the idea that state-owned banks could be helpful for jumpstarting growth in countries that are still struggling to recover from the recent global economic turmoil. Such advocacy would be short-sighted and irresponsible, since it runs so contrary to clearly observable evidence about the long-run effects of doing so. It would be highly unwise to create wasteful and corrupting fiscal time bombs in the form of state-owned banks out of a desire to temporarily boost aggregate demand during the current lean economic times. The immediate benefits , if any, would be short-lived, and the citizens of countries that take this approach would bear large costs for many years to come.

Comments

Submitted by Mike Graham on
The state bailing out state owned banks is more palatable than the State bailing out privately owned banks as recently happened.

Submitted by Del on
The Bank, IMF and Brookings held a conference on the topic back in 2004. Jim Hanson's paper can be found at: http://info.worldbank.org/etools/docs/library/83779/hanson_overview.doc A book was later published.

Submitted by Roy Culpeper on
This is a welcome and timely debate. However, the contributions critical of state-owned banks do not seem to take adequate stock of the lessons of the recent financial crisis (and previous ones for that matter), or of the lessons of two decades of financial liberalization. They also do not seem to be rooted firmly in economic theory. The key lesson of the crisis and of financial liberalization is that finance is a public good, or at least has strong public-good characteristics: Financial stability is in everyone’s interest. And even before the crisis erupted, there was a growing concern at the World Bank that despite (or because of?) two decades of liberalization, the financial sector denies access to the vast majority of individuals and small- and medium-sized enterprises in developing countries. Economic theory tells us that markets will under-produce public goods; thus there is a rationale for government intervention. In developed countries, at least, there seems to be a consensus that more and better regulation must be provided by the state in order to maintain greater financial stability. In developing countries, however, economic theory also suggests that there are large externalities to providing greater financial access to excluded individuals and SMEs. Ending financial repression and liberalizing financial markets has clearly not been sufficient to ensure that private banks will allocate credit to all those who can use it fruitfully—to the detriment of the economy and society as a whole, as investment, employment and growth fall below their potential. Of course, it does not follow that state-owned or national development banks will everywhere and always be effective. Governments too can fail: critics are right to point to numerous examples of failed or corrupt government initiatives in the financial sector. The most cogent position emerging from the debate thus far was articulated by Professor Allen, and others who have argued for more pragmatism and less dogmatism. This is the sensible suggestion that the best system is a mixed one in which national development banks coexist, compete with, and complement the private sector. We must learn from the failures both of governments and markets to provide adequate financial access and stability, in order to make them both better.

Submitted by Bob Cull on
In Franklin Allen’s initial post he noted that “public banks would also be able to provide loans to businesses—particularly small and medium size enterprises—through the crisis.” Subsequent commenters have also suggested that state-owned banks could play an important role in expanding access to financial services, or maintaining access to typically underserved segments of society during a crisis. And yet the empirical record provides no strong evidence in favor of state-owned banks promoting financial inclusion. As Sole Martinez commented in response to Charlie’s initial post, her research with Asli and Thorsten Beck shows no significant association between greater government ownership of banks and financial access across countries. With respect to lending to small and medium size enterprises, work that Sole and I did with George Clarke and Susana Sanchez showed that public banks in Latin America (Argentina, Chile, Colombia) were less likely to lend to SMEs than private domestic banks. We also failed to find a significant link between the share of banking sector assets held by state-owned banks and the severity of financial constraints reported by firm owners across 35 developing and transition countries. During the current crisis, Brazil was often pointed to as a country that weathered the storm relatively well. No doubt, state-owned banks do compose a large share of the Brazilian banking system and those banks did ramp up their lending while that of foreign and private domestic banks operating in Brazil flatlined, or declined slightly. However, our preliminary analysis of a large survey of Brazilian households shows that those located in areas where the network of public bank branches was relatively dense fared worse than others in terms of access to credit, and the effects were especially pronounced for self-employed people. Granted, there are methodological difficulties in establishing a causal link between the presence of state-owned banks and access to financial services for SMEs. For example, we do not know how Brazilian households would have fared in the absence of state-owned banks and their increased lending. And the existence of state-owned banks might not be exogenous to financial inclusion. But none of the evidence suggests that countries with large shares of state-owned banks fare particularly well in terms of financial outreach. In Kenya, a country Franklin and I are coming to know better as part of a new project, the outreach of the financial system has expanded rapidly in recent years. But that was due to M-PESA, a payments system based on mobile telephony, and to Equity Bank, both private endeavors. Despite having relatively extensive branch presence in underserved areas, the state-owned banks (which maintain around a quarter of Kenya’s banking sector assets) were not the catalysts for the increase. In his follow-up Franklin clarified that he is suggesting a more limited role for state-owned banks than his initial post seemed to indicate. But even in this limited role, it will not be easy for public banks to promote financial inclusion and to support small and medium size enterprises during crises. Lending to this market segment is notoriously difficult and costly, and it is unclear whether state-owned banks are the best vehicle for doing so. I agree with other commenters that ultimately it comes down to the mandates, incentives, management, and oversight of the state-owned banks. At the same time, based on the evidence that I know of, you can count me with Charlie among the skeptics, at least for now.

Submitted by Martin Cihak on
What is the “private banking” that Charles Calomiris and others are talking about? I am afraid that the distinction between state-owned and privately-owned banks has become blurred a long time ago, and it has become even more artificial during the crisis. There is no denying that finance is a sector with heavy state involvement. It was the case before the crisis, and is even more so now. State affects the financial sector in a number of ways, not only as a direct owner, but as provider of various guarantees, safety nets, liquidity support and other support mechanisms, as regulator and supervisor, and as provider of a range of critical financial infrastructures. The “too big to fail” policy has contributed to the blurring of the dividing lines between “state” and “private” banking. Unfortunately, the TBTF policy has been interpreted so extensively in many countries that even small “privately-owned” banks are considered “small but to save”. So, when we say “privately-owned” banks and when we compare them with “state-owned” ones, which privately-owned banks do we really have in mind?

Submitted by Heinz Rudolph on
I am not surprised by Bob Cull findings, and many others in the past, about the lack of a clear correlation between the presence of state financial institutions and economic development in emerging economies. Since most of the state financial institutions have not been properly managed, it would be difficult to find different results. However, if we keep looking at the past we will not move forward. The question that we need to answer is whether the root of the problem is structural to the ownership of the bank or it is more related to the lack of a proper hedging design for ownership structure. Back in the 80s, when Professor Calomiris began writing about these issues, our knowledge of corporate governance, risk management, and the boundaries of the financial systems were less clear. Fortunately for some of us (but not necessarily for Professor Calomiris) the corporate governance theory and risk management practices have evolved substantially, and hedging the shareholder risk it is something that it is possible to do and there are successful cases to show. Some other participants in this blog have mentioned the successful case of Banco del Estado de Chile, but it keep the sentiment that Chile is different and there are cultural issues that explain the behavior. I have studied the case Banco del Estado in detail, and I have found nothing cultural behind its success. It is purely an issue of hedging the shareholder’s risk and having the bank properly supervised by a competent banking supervisor. The experience of other successful banks shows that there are multiple ways of approaching this problem. Some of the preliminary lessons that we are getting from the recent crisis is that privatively owned banks do not necessarily bring economies into sustainable development either. The emergence of state financial institutions, together with other public support programs such as guarantee lines, emerges as an alternative when governments look for alternatives for protecting the most vulnerable sectors of the economy in the presence of economic cycles. Highlighting the risks of public financial institutions, and providing a consistent framework on how to mitigate those risks are the right policy advice that a mature institution like the World Bank should provide to its client countries. It would be short sighted and irresponsible not to apply the knowledge that we have gain in the past 20 years.

Submitted by Martin Cihak on
A side note to my previous comment: the differences between the financial sector and private sector is acknowledged also in the name of the FPD Development Network: it is Financial and Private Sector, with a distinction between the two. Yes, there are some "privately-owned banks" in a narrow sense, but given all the state interventions in the sector, how big is really the "true" private financial sector?

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