Editor's Note: The following post was submitted by Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at Columbia University, as part of the AAF Virtual Debates. In this opening statement, Professor Calomiris gives a negative answer to the question: "Can state-owned banks play an important role in promoting financial stability and access?"
It is quite correct to say, as Asli’s introduction to this debate noted, that academic work strongly supports “a growing consensus that the track record of state-owned banks has been quite poor” and has been associated with “inefficiencies, increased risk of crises, and less inclusion and greater concentration of credit,” and support for “cronies.” Not only do studies of the performance of state-controlled banks confirm these findings over and over again, the presence of state-controlled banks is so clearly understood to be a poisonous influence on financial systems that measures of the presence of state banking are often used as control variables when evaluating the performance of private banks. These studies indicate powerfully the negative effects of state-controlled banks on the banking systems of the countries in which they operate. The winding down of state-controlled banks was rightly celebrated in many countries in the 1990s as creating new potential for economic growth and political reform.
Why are state banks such a disaster? There are three main reasons:
First, government officials do not face incentives that are conducive to operating well-functioning banks. As my colleague Professor Rick Mishkin likes to say, banks are the “brain of the economy”—the institutions charged with the role of allocating capital wisely to those able to make best use of this scarce resource. Government officials tend to focus on other objectives, and they face incentives that reward politically motivated, rather than economically motivated, allocations of credit. Additionally, they tend not to be trained in credit analysis as well as private bankers, and they are typically not incentivized by governments to maximize economic effectiveness (since that is not what the political masters of the bank want it to do).
Second, the politically motivated allocation of funds to crony capitalists has adverse consequences for the political and social system of a region or country. State-controlled banks are a breeding ground for corruption of elected and appointed government officials, the financial regulatory authorities, and the courts. Not only do they stunt the growth of the economy, they also weaken the core political and bureaucratic institutions on which democracy and adherence to the rule of law depend.
Third, state-controlled banks are, in the words of Professor Gerard Caprio, “loss-making machines.” Because they are not geared toward profitability or the aggressive enforcement of loan repayment, but rather toward rewarding political cronies with funding, the losses of state-controlled banks pose a major fiscal cost for governments. Those fiscal costs crowd out desirable government initiatives, and given the large size of the losses, can be a threat to the solvency of government and a source of inflationary deficit financing.
It is remarkable to me that the recent economic crisis has spurred a renewed interest in state-controlled banks. From my perspective, the crisis has only reconfirmed the extreme damage that politically motivated lending can inflict. The quasi-state-controlled U.S. entities Fannie Mae and Freddie Mac accounted for more than half of the funding of subprime and Alt-A mortgages leading up to the crisis. There is clear evidence demonstrating that political motivations drove the intentional risk taking and deterioration of underwriting standards at those institutions after 2003—a crucial ingredient in the subprime boom of 2004-2007. Government quotas dramatically increased the funding that Fannie and Freddie had to supply to low-income and underserved borrowers, but the supply of creditworthy low-income and underserved borrowers was limited. As an inevitable consequence, lending standards were relaxed. Emails between risk managers and senior management show that managers entered into undocumented mortgage lending in 2004 primarily out of a desire to meet politically driven mandates.
The U.S. experience is not unique. Political motivations drove Spanish cajas to support a real-estate boom that ended in a massive bust. In Germany, state-controlled banks also made horrible investment decisions, in this case perhaps reflecting incompetence more than corruption or political motives for channelling funds. Looking back historically at other cases of extreme booms and busts, or at the modern literature on state-controlled banking, it is clear that state-controlled lending has been a major contributor to unwise and politically motivated risk taking that has ended badly over and over again.
Why, then, is the crisis reviving interest in state-owned banks? The huge crisis-related losses of equity capital in the banking system and the subsequent stepping up of regulatory oversight over banks have resulted in a short-term contraction in the supply of credit. This credit crunch magnified the decline of GDP during the recession, and slowed the pace of the recovery. As my own research on the effects of credit contraction during the Great Depression shows, it can take several years for the effects of such a credit crunch to dissipate.
In such an environment, it may seem appealing to pass a law creating a state-owned bank with the goal of re-starting the rapid flow of loanable funds. But such an initiative would be short-sighted in the extreme. Rather than promoting sustainable growth, it would slow growth over the medium or long run, as funds would be channelled to low-productivity users. A move to support state-controlled banks would not only lead to waste and slow growth, it would raise systemic risk (as Fannie and Freddie, and the Spanish cajas so clearly show), promote corruption of our government officials and institutions, and lead to fiscal losses that could threaten the solvency of government and lead to high inflation.