The Structure Of The Banking Sector: Private Vs. Government Ownership Of Banks

Introduction

Financial systems vary across all countries in the world and range from rudimentary to trailblazing, making some relatively fragile and others much more stout. There is a growing number of literature and empirical analysis that provide a ground of evidence that well- functioning financial systems can increase the rate of growth of a nation’s economy. However, it is difficult to truly establish a causal effect between a strong financial system and government intervention in the banking sector.

Financial deregulation during the last few decades is believed to have led to a more competitive and efficient banking system. Despite increasing economic growth, it has also brought forth financial vulnerability and instability, particularly in countries whose institutions are weak. These vulnerabilities to financial systems were mainly recently seen during the 2008 financial crisis and the years that followed up, where many banks posted losses and numerous countries had to intervene in the banking systems of their respective countries to save private banks from going under.

Government involvement in the banking sector has increased over the past decade, especially in developing countries. However, these same countries saw a decrease of public ownership in banks in the same period that developed countries experienced an increase in government involvement in the banking system. A bank is referred to as a “state bank” if 50 percent, or more, of the equity of such entity is owned by the government. Therefore, a bank has to be majority-owned by a state-owned entity to gain such status. A known example in the Netherlands, which will be referred to later on, is ABN Amro.

Government intervention in the banking system has been a trending topic after the 2008 financial crisis. However, several years before the crisis even occurred, American economist Joseph Stiglitz argued that the two main reasons for the government to have a stake in banks are political motives and institutional deficiency.

In this paper I will investigate the different implications between public and privately owned banks. Moreover, I will discuss the contribution and effects of the different types of ownership on the vulnerability, stability and efficiency of the financial sector. Furthermore, I will go on to analyze the existing literature on the risk for public finances due to the different ownership. Finally, I will see how these three issues have been dealt with in two countries who have had very different interventions in the banking system following the 2008 financial crisis; the United States and the Netherlands.

Risks for Public Finances

The risk for public finances can be defined as the risk of the government having to intervene and spend a large amount of taxpayer-backed funds into helping the financial system. The two main risks are state-run banks and too-big-to fail banks. Government banks can produce a rather large deficit on the public finances through being subsidizes, while private banks pose a large risk of perhaps an even higher amount if they face bankruptcy.

When there are both private and government owned banks in the market, private banks will offer a higher interest rate to depositors due to the higher risk exposure. Government-owned banks have lower risk because they have backing from taxpayers, whereas private banks can only lose money until they become bankrupt. Even when considering cases of countries with highly developed financial systems, state banks are also known to bare less risk and therefore have a lower cost of capital than private banks.

Ianotta et al’s research paper on the impact of government ownership on bank risks finds that private banks have a higher default risk relative to state-run banks. However, it does not mean that governments-owned banks take on less risk in their portfolios. Controversially, their findings show that state banks have higher operating risk and can afford to do it due to having government support. In fact, due to this buffer that state banks have because they are backed by the government, state banks have an incentive to compose their portfolios with a higher risk profile than private banks do. This paper also finds that government owned bank’s operating risk and protection tend to increase during electoral periods, which confirms Stigliz’s previously mentioned hypothesis about governments intervening in the banking sector for political motives.

Private Banks, on the other hand, can become a dangerous component of the financial system and a threat to the economy when they reach “Too Big To Fail” status. Systematically important private banks acknowledge that their failure will only lead to a situation in which they have to be helped with taxpayer money. Therefore, these institutions have a lower incentive to make welfare maximizing decisions and instead have a higher incentive to earn short term profits by taking on more risk and leveraging up. Due to several banks knowing that they are too large of a component of the financial system to fail, they know that government support will come in case of bankruptcy, even though it will harm society on aggregate.

Thereby, governments might have relatively high incentive to increase state-ownership of banks to prevent the negative outcomes that can cause a large dent in the financial structure of a country, either because of a bank’s effect on its customer or on other banks. Government-run banks should have the incentives more aligned with a country’s population than private banks do. While state-run banks might also allow for fluctuations of political economy, they create a buffer against the negative effects for public finances when large private banks need to either be “bailed in” or “bailed out”, at a time which it is very costly to intervene.

Efficiency and Stability of the Financial System

Based on the existing cross-country empirical evidence, it is exceedingly challenging to confidently state that restricting commercial banking activities either benefits or diminishes financial development.

Barth et al. find that countries with greater restrictions in the banking sector, particularly on securities, have a substantially higher probability of suffering a significant banking crisis. To be more precise, those countries with national institutions that strangle the capabilities of banks to freely engage in securities underwriting, brokering, dealing and all aspects of mutual funds tend to have more fragile financial systems.

Furthermore, a higher degree of state ownership of banks is associated with poorly developed banks, non-banks and stock markets in the respective countries. Therefore, although state ownership helps banks overcome informational problems and align the incentives scheme more than private banks, they also invest scarce capital in less productive projects that lead to lower efficiency. Therefore, on average, state ownership of banks is associated with a more detrimental financial system. Furthermore, have found evidence that government-owned banks that have access to subsidies by their respective governments partake in more aggressive risk-taking activities, which can thereby distort competition with privately-run banks who do not have the backing of subsidies.

Moreover, the “political view of government banks” by Serdan Dinc states that bank lending can be politically motivated. State-owned banks are meddled and run by polititians who use it as a method of altering the economy in their favor to capture a higher percentage of voted. Particularly during election periods, Dinc finds that lending increases more for public than private banks. Such findings are also consistent with numerous other papers in specific countries such as India, Pakistan, Brazil and Italy. Such credit-misallocations lead to inefficiencies in the credit market as well as distortions in the relative competitiveness of private banks.

When comparing performance according to ownership without controlling for bank characteristics, La Porta et al. found that state banks post lower profits than private banks. The percentage of government stake in the financial banking system is negatively correlated to financial development and economic growth. However, the findings also suggest negative effects of increase government ownership, such as financial instability.

Evidence by Micco et al. provides us with knowledge that private banks in developing countries are far more profitable than those of government ownership. The main driver of this performance differential is caused by the exceedingly weak performance of public banks during election years.

Despite lending from public banks being very dependent on the election years, it is shows by Bertay et al. (2012) that private bank lending can be increasingly procyclical, and even more so if they are foreign-owned banks, and state banks are less procyclical. Furthermore, after the Basel II capital accords, it is expected for private banks to accumulate profits during years of economic growth and limit their credit during recressions.

According to Demirguc-Kunt & Huizinga, lending by public banks is less procyclycal than the lending by private banks, especially in countries with good governance. Furthermore, if government-owned banks are in countries with high quality of governance, the lending can possibly even be countercyclical. This is because the government mainly needs to intervene in the financial system when the economy is having weak growth or is in a recession. Therefore, a government with high effectiveness can increase the quality of public services. However, the bank has to have a high degree of independence from the government, to avoid political corruption. Furthermore, state-run banks should have the credibility of a government backing to assert higher importance, leading to more efficiency. The study by Huizinga et al. also found that the growth rate of public bank’s total liabilities is lower than that of private banks during periods of economic growth.

Andrianova et al. also analyse, the relation between government ownership and regulation. It is found that government ownership can be a proxy of weak regulation. Therefore, it concludes that state banks are only effective at their purpose in countries with weak regulation. However, as noted above, state banks are always associated with higher economic growth across all countries. The sample used was for the years 1995-2007.

Country-Specific Cases After the 2008 Financial Crisis

In 2008, there were a financial crisis that began after the fall of giant investment bank Lehman Brothers. This resulted in the biggest recession since the Great Depression and resulted in very high levels of unemployment all of the world, along with the collapse of many banks. The crisis showed how vulnerable the financial system really was.

To avoid worse repercussions, many countries had to intervene in the financial system to save banks, either bailing them in or bailing them out. This was the case for many “Too Big To Fail” banks.

On October 19th of 2008, the Dutch parliament had to shore up buffers for the banks to not default and to save the country’s financial system, with ING’s 10 billion euro capital injection being the most wide-known example. Later on, however, the third biggest Dutch bank, ABN Amro, had to be taken over by the government to save it from bankruptcy. This was a very brave move, because the goal was to get the bank back on its feet and then sell the equity once it had been stabilized.

According to the literature previously mentioned, it made sense for the Dutch government to take over ABN Amro. They had taken on excessively risky behavior via toxic foreign assets, to the extent that it caused the bank to consider bankruptcy. Therefore, the government had to intervene to restore confidence in the market, to insure the savings of millions of bank account holders and to keep jobs. Overall, all such actions helped the Dutch financial and banking system.

In the United States, just a couple of weeks earlier, on October 3 2008, treasury secretary Henry Paulson proposed the Emergency Economic Stabilization Act of 2008. This is also known at the bank bailout of 2008, within which the Troubled Asset Relief Program was targeted. This program would enable to United States government to purchase toxic assets from financial institutions. These were mainly assets that caused the subprime mortgage crisis. The government purchased 700 billion US dollars’ worth of troubled assets from banks as a way to inject capital into the financial system and prevent a financial meltdown. The goal was to stabilize the economy, improve liquidity and restore investor confidence, among others goals. However, it was very argued by economist Paul Krugman that equity capital should have been the exchange for the monetary sum that banks received, and not toxic assets with an unknown market value. It was crucial that the government stepped in, but it was too little, too late. Berger et al. (2019) did the first empirical analysis on the effects of TARP on systematic risk. Theoretical macroeconomic theory would suggest that government aid to banks could either diminish or augment systematic risk. Their results suggests that TARP significantly aided the financial system through the reduction in systematic risk, especially for banks of larger size and safer portfolios, and also those in better local economies. The main effect can be seen through a capital cushion channel that helped reduce overall market debt through the increase of the value of common equity.

Conclusion

Overall, there are numerous differences between the operations of state-run and public banks, which go on to affect the financial system. Two of the main consequences of such operational differences and motives are the risk for public finances and the efficiency and stability of the financial system, as noted above.

Conclusively, there are many country-specific factors that affect the overall conclusion of whether banks should be private or public. Although numerous variables have been used to test differences, there are still many more differences, such as culture that could be used as a proxy to quantify efficiency of each banking regime.

From the existing literature we can arrive at the conclusion that every country could have possible different benefits and disadvantages of having a state-run bank. However, some advantages prevail for both sides of the argument in every country, and those are the ones I tried to focus on in this paper.

The political economy is one of the main reasons for debate, as it is empirically shown that several countries increase lending during periods of electoral votes. This shows that politicians can potentially use state-run banks to influence the outcome of electoral campaigns. Moreover, ties to the politicians can also alter the lending pattern in some countries.

The efficiency of state-run banks is also a controversial area of debate. On the one hand, they can take on excessive risk by knowing that they have a capital buffer in taxpayer funds. On the other hand, it is very risky to have a state-run government that takes on excessive risk because it then promotes excessive risk-taking among all banks that compete with them, giving rise to financial vulnerability and a shift in the competitive equilibrium in this market.

Overall, however, state-run banks could possibly be more likely to have the country’s population best interest in mind, and not simply profit-maximizing as private banks do. Therefore, they could also be a buffer for the financial system when private banks take on too much risk to increase their net income.

There are too many factors that vary by specific case whether which form of bank is better. The best answer is that it varies by countries. However, there are numerous examples that we can learn from to use as a drawing board for later policies and as a way to prevent from another grand financial crisis as the one in 2008. Some countries should therefore have state-run banks and other should perhaps not.

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