Private versus Public Banks: The academic evidence

In France, about two thirds of the banking system is owned by the public sector. In Germany, that proportion is even higher – about 75%. In Spain, the public sector owns no banks outright, but the public sector is still a dominant player among the savings banks. In Italy, the situation is interesting. In 1990, Italy had a similar banking structure to Germany, with about 70% of the banking sector stated-own. That proportion went down to 9% by 2005.

 
The creation of a single European financial market is often viewed as one precondition for the success of monetary union in the long-run. The EU’s Financial Services Action Plan is one part of the process towards a harmonized financial sector in the EU. But for the euro area specifically, the ambitions the ambitions should go beyond concepts such as market access and harmonization. There is a strong case for a single banking market in the euro area, supervised by a single banking regulator (the ECB for systemic risk, and a still to be created body for non-systemic risk).

The history of the EU’s internal market has demonstrated that harmonization works best on the basis of market deregulation. It is no surprise therefore that the EU most successful programme of all times, the single market, follows a large liberal agenda. We argue in this briefing note that the EU – and failing that euro area countries specifically – should adopt a similar attitude towards the creating a common European banking market. A precondition is a policy to reduce the national and local governments involvement in the banking sector.

In this briefing note, we present academic evidence against the role of the public sector in the banking system. It draws heavily on a conference held in Frankfurt on November 17/18 entitled “Public versus Private Ownership of Financial Institutions”, organized by the Center for Financial Studies in Frankfurt, the Bundesbank and the Wharton School of the University of Pennsylvania. While practitioners, especially representatives of savings banks and other non-private sector banking institutions, defend the status-quo, the academic literature overwhelmingly rejects the influence of the state, both on theoretical and empirical grounds.

The theoretical objections to state-owner in the banking industry are relatively easy to summerise. Money is obviously no public good. Since fiat money constitution a social contract between the individual and the state, there is a strong theoretical case for a state-owned monetary authority. But this argument does not extend to the distribution of money.

Market failure, and the large externalities that might follow from this, are another potential argument in favour of a public sector involvement. But it is theoretically not clear why the state cannot devise other forms to correct market failures, for example through regulation. It is not clear at all why there should be a greater risk of market failure associated with a well regulated private sector than with an equally well regulated public sector.

There are non-market arguments in favour of public-sector bank ownership: poverty alleviation, financial development, special focus on companies and individuals who might not be creditworthy. Here is where the empirical literature comes in. Ross Levine, in a presentation about the empirical evidence from the finance literature, put the pros and cons of government-owned banks (GOB) in following terms:

Pros

1.      Overcome collateral problems of small firms

2.      Overcome lack of credit histories of new / small firms

3.      GOB may fund best social projects

4.      Coordinate large scale / strategic endeavors

5.      GOB fund projects that reduce poverty

6.      GOB achieve other socially efficient aims

Cons

1.      GOB do not have better information

2.      GOB promote private interests

3.      GOB do not identify / fund strategic endeavors

4.      GOB promote private interests

5.      GOB do not achieve other socially efficient aims

The potential theoretical arguments in favour of government-owned are almost all contradicted by the empirical evidence.

1. The prevalence of GOB is negatively correlated with economic growth.

2. Banks perform better after privatisation

3. GOB are also hinder financial development

4. GOB do help with poverty reduction

Some results from academic studies have shown that GOB lend money to projects in which government politicians are involve or to regions of particular parties. Some studies have been carried out for Pakistan and Japan, but while there are fewer data available for European countries, there is at least anecdotal evidence that politicians have used private-sector banks for their own purposes. For example, in the late 1990s Gerhard Schröder, the state premier of Lower Saxony, authorised a GOB loan to bail out Salzgitter.

What further evidence have we got? A study by de Vincenzo, Firoentino, Heid, Karmann and Koetter found that technology was the main driver of higher factor productivity in Italian and German banks, but that privatization added to TFP in Italy directly. This result is consistent with Levine’s critique according to which GOB are bad for growth.

The evidence is more mixed when it comes to financial stability. De Nicolo and Loukoianova found that the previously established position relationship between bank concentration and bank failures is strongest when state-owned banks have sizeable market shares. However, contrary to the mainstream financial literature, Hesse and Cihak find that cooperative banks are more stable than commercial banks.

All in all, the literature is relatively skeptical on the benefits of government-owned banks, and relatively neutral on co-operative banks.