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The AAF Virtual Debates: Franklin Allen on State-Owned Banks

Franklin Allen's picture

Editor's Note: The following post was submitted by Franklin Allen, the Nippon Life Professor of Finance and Economics at the Wharton School, as part of the AAF Virtual Debates. In this opening statement, Professor Allen gives an affirmative answer to the question: "Can state-owned banks play an important role in promoting financial stability and access?"

The prevailing view in the academic literature holds that private banks are much superior to state-owned or public banks. In many emerging-market countries public banks have been corrupt and inefficient. In contrast private banks have performed much better in terms of efficiently allocating resources over the long run.

However, the crisis has underlined the fact that public banks enjoy several advantages over private banks, and their merits may need to be reevaluated. At the height of the crisis in the fall of 2009, the three largest banks by market capitalization in the world were all state-owned:  the Industrial and Commercial Bank of China, China Construction Bank, and Bank of China. Although they are publicly listed, the Chinese government owns the majority of their shares. Their structure provides an interesting governance model. Perhaps more importantly, most large privately owned banks in Europe and the U.S. received government funds and guarantees during the crisis. Without this government intervention, many would have failed. The governments bore the downside risk but without full control, generating a significant moral hazard problem in these banks’ future operations.

One approach to safeguarding the financial system during times of crisis is through a mixed system, with most banks being private but with one or two state-owned commercial banks. In normal times they would compete with private banks to ensure their cost structure is competitive and corruption is avoided. They could in fact help promote competition if the private banking structure is oligopolistic. These public banks would also provide useful information to regulators: if private banks are making significantly higher profits than public banks, this may provide a warning signal that they are taking too much risk or exploiting their monopoly power.

But the real advantage of public banks would become evident during a financial crisis. Such banks would be a safe haven for retail and interbank deposits. They would also act as a fire break in the process of contagion. Public banks would also be able to provide loans to businesses—particularly small and medium size enterprises—through the crisis. They could expand and take up the slack in the banking business left by private banks. In the current crisis many central banks such as the US Federal Reserve were forced to take on the role of a commercial bank with many of their lending programs. However, making credit decisions is not central banks’ expertise, and they are unlikely to perform this role well. A state-owned commercial bank would be much better able to undertake this kind of role. As with Chinese banks, listing such banks publicly will ensure that full information on them is available and that a stock price indicates how well they are performing.

Public banks can play another important role in increasing access to financial services. If the government wishes it to pursue this agenda then it may be helpful to subsidize this kind of activity. In many European countries in the nineteenth and twentieth centuries, the post office provided access to savings accounts and other kinds of financial services that many customers would not otherwise have had.

A good example of a public bank that plays these roles is Chile’s Banco del Estado , which is 100-percent owned by the Chilean Government. It is the country’s third largest lender and operates in all major segments of the banking market. The fact that it has to compete with private banks ensures it is well run. It can play an important role in times of crisis. Banco del Estado also has a long history of promoting access in all parts of the country and to all people. Many other countries might benefit from this type of bank.

Comments

Submitted by joebhed on
Of course there are very good and bad examples of state banking efforts. And, of course, we're not talking like the Bank of North Dakota, one good example. More like the Bank of the United States. The United States Bank. As a means for providing a much-needed modicum of stability to international 'finance', it could do the job. But the too-heavy-to-weigh gorilla in the room that must remain on the sideline while we deal with our evolving emergency in the world's money system is not state banking but state money. And so, in favor of state money, may I bring to your attention the work of renowned Japanese economist Dr. Kaoru Yamaguchi. In a most timely work presented only last July, Dr. Yamaguchi has done extensive macro-economic modeling of a change to a public money system, where money is issued without debt directly into the economy. The results of the transition to a debt-free money system are measured in achieving economic growth without inflation or deflation. While, over time, paying off the national debt. Also, very fortunately, Congressman Dennis Kucinich has introduced legislation to achieve just such a result. So, you might want to think about spreading that out over the globe as a means of achieving real financial stability. It's better than having states of any kind in competition with private finance. Let the government create the nation's money, like it should. And let the bankers get back to banking. Thanks.

Submitted by Nachiket Mor on
My personal experience is entirely limited to India and its States and therefore may be incomplete but I find the logic of the post from Professor Allen not at all appealing for several reasons: 1. The presence of the public sector in financial services changes the incentive structure of regulators and the government almost entirely, to the point it blurs the separation between these entities and instead of overall development of the sector the principal objective becomes protection of the public sector. 2. Tax bailouts of one form of another become the norm and not the exception and are often hidden deep inside the balance sheets of public financial institutions. For example, the reason the banking license is such a highly desired commodity in India is principally due to the repressed interest rates on current and savings accounts (representing between 30 to 40% of bank balance sheets) which virtually guarantees profits for even the most risk-averse and inactive banks. Loan waivers for large farmers, large scale bailouts of failed cooperative banks and regional rural banks are a matter of course and do not even figure in discussions of crises -- which is why several of us in India feel that we have "escaped" the sub-prime crisis entirely. 4. The most significant problem is that even a small public sector and the need to protect it, constantly forces the system to operate with a low benchmark of performance and risk management, gradually setting a standard for the entire system, even the private sector. Conscious of this the Regulator seeks to compensate with more and more detailed regulation and rules further weakening the internal capacities of the financial institutions. Bank failure is then correctly seen as the failure of regulation forcing the Regulator to take steps to ensure that it never happens. This leads to enormous Moral Hazard as shareholders, management and depositors all transfer their respective supervisory roles also to the Regulator. The Regulator then constantly cites the limits to its regulatory capacity as the most significant barrier to allowing an increase in the number of players thus moving the system towards a strong pro-incumbent-bias who in turn gradually become too big to fail thus further reinforcing this trend. 5. As the two Andhra Pradesh MFI crises so graphically demonstrate (both in 2006 and more recently in 2010) the "official" sector fights back with all the power at its disposal when the private sector threatens its primacy. When the vocal middle classes are involved the restrictions have to be much more subtle (introduction of licensing for ATMs) but when the loss of control over the vote banks of the poor are involved the political interest also becomes fully aligned and the wholesale destruction of the private sector becomes a feasible option. There is no question that financial systems need strong regulation and in my view for that reason there is need for a Regulator that is completely independent and without the confusing mandate that the presence of public sector financial institutions implies. The need to balance systemic stability with the need for evolution of the financial system, in my view needs a Regulator and a systemic design that is fault-tolerant but not error-free. It allows for failure of financial institutions without threatening the stability of the entire system. On this blog post (http://bit.ly/DesignChoices) Bindu Ananth and I explore some alternative designs that have this character.

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