Published on All About Finance

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

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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.


Franklin Allen

Professor of Finance and Economics, Director, Brevan Howard Centre, Vice-Dean of Research and Faculty of the Business School, Imperial College

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